Bearspread's better

DERIVATIVES

Although all positions taken this close to settlement are subject to expiry risk, the skewed pay offs make one favour the 4250 -4200 bearspread.

The market completed a bullish breakout this week and consolidated "� or at least, the Nifty did.

As a result, open interest swelled across F&O and premiums rose in the options market. This makes it very likely that the settlement will come through in buoyant conditions despite continuing concern on the currency and interest rate fronts.

Index Strategies
The spot Nifty closed at 4248 with the May futures contract settled at 4260.65 while the June contract was settled at 4254. Open interest declined in the may contract but it increased quite strongly in the June contract.

The BankNifty was down 1.4 per cent, closing at 6200 on fears of a rate hike and the BankNifty May Futures contract was settled at 6228.90. The spot CNXIT was practically unchanged at 5309, despite another bout of rupee strengthening. The May futures was held at 5337.05. There is still no appreciable open interest in the June futures of either of these indices.

The May-June differential offers scope for a minimal calendar spread in the Nifty with a long June, short May combination that would gain as the two series align. However, given margin and brokerage, this spread can scarcely be profitable since the differential is wafer-thin.

In the CNX IT and the BankNifty, sell offs in both futures contracts seems reasonable, given that the futures are trading at substantial premium to the spot.

But this will backfire if there is enough appreciation to ensure that the spot cross the current futures' levels. The technical perspective on both indices is actually mildly bullish because most of the big banking and IT stocks did well on Friday.

From June, the NSE will also offer contracts on the Junior Nifty and the CNX100. It remains to be seen what that will do to volumes and OI across the index futures segment.

But it is a very positive step in the long run and it will undoubtedly make life easier for operators and trading in those stock universes. Perhaps the NSE will now consider adding a contract in the dollar-denominated Nifty, which would allow hedging of currency risks?

In the Nifty options market, the rise has led to a big increase in OI which is unusual at this stage of settlement. It has also meant that call premiums have stayed firm close to the money which is also unusual close to settlement.

The put-call ratio of the Nifty is at 1.38 "� that's practically the same as it was around May 18. The high PCR suggests that this settlement will go through smoothly.

OI has also expanded substantially in the June options chain, which means there will be a lot of carryover. The market should stay firm until settlement at least though there may be high intra-day volatility.

That perception has led to mispricing. A bullspread in the Nifty with long 4250c (44.95) versus short 4300c (21.95) costs 23 and pays a maximum of 27. A bearspread of long 4200p (17.5) versus short 4150p (10) costs only 7 and pays a maximum of 43.

In theory, that's an extraordinary risk:reward ratio. Even an in-the-money long 4250p (32.15) versus a short 4200p (17.5) costs just 15 and pays a maximum of 35.

In practice, both the bearspread and the bullspread could be struck given normal volatility in a settlement week. Of course, all positions taken this close to settlement are subject to expiry risk. But the skewed pay offs make one vote in favour of the 4250 -4200 bearspread. This is on the money so, it is almost certain to pay off.

Suppose you go with a long June 4250c (111.8) and sell a June 4300c (85.45)? The net cost is 26 and the pay off is 24. That's an adverse risk:reward ratio but the position will be "live" until June 28. That makes it a better position than the May bullspread in my opinion.

A long strangle of long 4200p and long 4300c costs 62 and breakevens outside Nifty 4138-4362. That is a little too far for comfort. I suppose a deep reversed strangle of short 4100p (6.45) and short 4350c (7.7) can be sold.

This is profitable if the market stays inside 4085-4365. But the returns are small and you may not find a counter-party.

STOCK FUTURES/ OPTIONS

There were a few trends visible in the stock market. Banks dropped through most of the week and rose on Friday. IT stocks rose on Friday. Refiners dropped as the price of crude hardened. Power sector stocks rose.

But much of the interesting action was stock-specific and driven by news. For example, Patni Computers shot up on rumours that it was being targeted for takeover. HDFC rose because Cargill bought a stake.

Speculators started calculating the possible value-unlocking of Reliance Capital's holdings in ADAE group companies. United Spirits continued to rise on the news of the W&M takeover. The Tata Steel "�Corus financing drama continued. RPL and RIL continued to move up.

The biggest move was of course, that of Suzlon on the basis of winning the RE Power bid. The stock shot up by a huge amount and the futures jumped into the top league in terms of contract activity. Unfortunately, it doesn't have much option OI.

In fact, the only stock that seems to have an abnormal level of option OI is Reliance Petroleum. RPL is trading at about 98.25 in spot and the 95C is priced at 3.9 with massive OI. Unfortunately, there isn't enough differential to arbitrage either way.