Build bear spreads

DERIVATIVES/ High implied volatilities suggest there could a big move in either direction

Most of the market action is likely to be postponed until May so, it will occur only in the next derivatives settlement. As of now, the market is poised uncertainly inside a narrow trading range. Next month is likely to see a big breakout in either direction.

The odds are that the market will move up sharply in May, perhaps going to new all-time highs. There is also a chance of a 5-10 per cent drop if the elections lead to unexpected results.

April Nifty futures are at 1891.5 with May futures placed at 1893.85 and spot Nifty at 1892.45. In these circumstances, a calendar spread where the April future is sold and May is bought makes sense. Either a drop in April or a rise in May values or, in the best-case scenario, a combination of both moves would result in profits for this spread.

As to the options market, our perspective is that the index could move anywhere between 1830 and 1920 within April and anywhere between 1830 and 2000-plus in May. There isn't enough liquidity in May options to make spreads there worthwhile as yet. So, we need to concentrate on April options.

With the settlement to come this week, there is little time to expiry. Implied volatilities are quite high, suggesting the market 'knows' there is likely to be a big move in either direction. The temptation is to create positions by selling options due to the large premiums available.

However, this may be dangerous in these specific circumstances given the market holiday linked to elections in Maharashtra. You may get stuck in a position, which incurs massive losses. Premiums could also move unpredictably as time-decay is coupled to market uncertainty.

However, let's look at some specific possibilities. Our perspective for April suggests that bear-spreads are more likely to be profitable within this narrow timeframe of three trading sessions.

A normal bear-spread of say, a long 1880p (15.65) coupled to a short 1870p (11.85) or 1860p (8.5) is possible. This would offer a maximum return of 12.85 for an outlay of 7.15 or a return of 5.20 on an outlay of 4.80.

The wider spread offers a fair return. A long 1870p versus short 1860p offers an even better return of a maximum 6.65 on an outlay of 3.35. A bear-spread with a short 1900c (16.75) versus a long 1920c (9) offers a maximum return of 7.75 for a possible loss of 12.25. The return-risk ratio isn't good enough in my opinion to take these positions.

Bull-spreads in the timeframe of April are less likely to pay but the return ratios are reasonable. The market could move from current 1890 levels to around 1920 in the next three days. So a long 1900c versus short 1920c would pay a maximum of 12.25 for an outlay of 7.75.

If you wish to exploit high premiums close to money, straddles and strangles look especially interesting, given the time-decay factor. Suppose we take a short 1880p (15.65) and a short 1900c (16.75).

The position pays an initial premium of 32.40. It would go into losses only if the market moved outside the range of 1850-1930. It's unlikely to see such a wide movement inside this settlement.

This short strangle can also be covered with a long 1850p ( 5.8) and long 1930c (6.5) for an outlay of 12.3. The resulting combination is illustrated in the graph. This would stay profitable inside 1870-1910 and restrict losses to a maximum of 10 outside that range.

Where May is concerned, we should be braced to take long positions in the options market, the instant there is sufficient liquidity. This probably won't happen before Friday however.

As far as stock options are concerned, banks and cement stocks appear to be bullish with a certain amount of interest available in pharma and IT stocks as well. There are no obvious short positions in the stock options market despite our perspective that there could be a short-term decline in the coming week.

The May futures of all the PSU banks available in the F&O segment appear to be worth a buy - that's rather a long list. ICICI also looks to be an excellent shot.

Perhaps we could contemplate calendar spreads in bank futures where April futures are sold and May Futures are bought. This would pay more than the naked long May position in circumstances where the April future is currently trading at a premium. Otherwise it may be more profitable to just hold the long May futures.

Among cement stocks, long May Futures of ACC and Gujarat Ambuja seem to be more likely to offer high returns than Grasim. Among pharma stocks, long May futures in Dr Reddys and Cipla seem quite likely to fetch returns. Mastek is very strong in the cash market and that should translate into a move in the May Futures as well.

There is little play in the stock options market. ICICI Bank is an obvious case where premiums have failed to keep step with the uptrend. A long 320c (5.6) versus short 330c (2.15) would pay a maximum of 6.55 for an outlay of 3.45. The premiums are likely to jump however so current prices are not very useful.

In Mastek, it is possible to take a long 280c (8.5) with fair chances of gains. However there is a liquidity problem above that price so, unless liquidity develops on Monday, this would be a naked position.