Bull spread offers a better risk-reward ratio

Even a decisive breakout did not trigger higher volumes in the futures and options (F&O) market. Liquidity and open interest remained at low levels through last week and the FIIs continued to hold the whip hand with over 45 per cent of all outstanding F&O positions.

Index strategies:

The overwhelming importance of FII activity in the derivatives markets has made trading strategies simple for them. They can take "Texas hedges" "� go short when they are selling in cash, and long when they are buying, secure in the knowledge that there are no credible challengers. It has also caused a vicious cycle where domestic operator volume has faded away and retail volume has been wiped out while the FII activity has become ever more important.

Eventually this cycle will break but there is no sign of it so far. Meanwhile the market itself has broken. After the breakout, near-term index futures are generally trading at discounts to spot values and liquidity has disappeared in mid-month and far-month contracts. The newly-introduced long-term options are generating only token trades.

In an apparently overwhelmingly bearish scenario, there are a few thumb rules. The market is looking oversold and when it does bounce in an upwards technical correction, it will bounce sharply precisely because of the low volumes. There is apparent danger in keeping overnight positions because of high volatility. But volatility has started to ease off a bit and both chart-analysis as well as a look at outstanding open interest patterns suggests that there is good support below current prices.

Traders looking to play in this scenario will have to keep lots of margin in reserve and if possible, stick to the Nifty and the top 10 stock futures. But it might make more sense to stay long and wait for the bounce rather than staying short. There are still 3 weeks to settlement and an upmove is almost guaranteed before that happens.

Comparing index futures to spot, the Nifty closed at 4,771 while the March future was settled at 4,726 and April at 4,712. There is almost no volume in May. The Junior closed at 8,243.1 and it was settled at 8,194.95 but there was hardly any open interest. The BankNifty closed at 7,268.15 and it was settled at 7,268.4. The CNXIT closed at 3,762.05 and it was settled at 3,719.6. The Midcaps closed at 2,483.8 and it was settled at 2,496.25 but again, there was only token open interest. Insofar as one can draw inferences, the BankNifty is the most oversold and short-covering is already occurring there. There could be some downside to other indices.

In the Nifty options market, the Put-Call Ratio (PCR) in terms of open interest is at 1.06, which is slightly on the low side but not quite oversold. Over 90 per cent of open interest is concentrated on the March contracts and the March PCR is 1.01. Again, one could interpret this almost-neutral PCR as a situation where there is still a downside. Looking at specific contracts, the open interest in the 4,700p and the 4,600p contracts is enough to provide support. Similarly, there will be resistance at 4,900, at 5,100, and at 5,300 due to the overhang of calls at those strikes.

Thus, the market should bounce before the 4,600 level and it has a possible upside till 5,300, though it's more likely to halt between 5,000-5,100. Between now and settlement, the market is very likely to traverse 4,600-5,100 and quite likely to traverse 4,600-5,300. If it does fall below 4,600, it could go down till about 4,200. On a daily basis, the historic volatility suggests that a high-low range of 150 points is likely.

A bull spread of long 4,900c (117.9) versus short 5,000c (80.35) is fairly near-the-money and costs about 38. It could pay 62. That's a good risk-reward ratio. A bear spread of long 4,700p (192.8) and short 4,600p (150.05) costs about 43 and it could pay a maximum of 57. That's still a comfortable risk-reward ratio although the bull spread is better.

If we combine these positions, we get a long strangle of long 4,700p and long 4,900c coupled to a short strangle of short 4,600p and short 5,000c. The net cost is 81 and the potential maximum gain is 19 on either side. Unfortunately there is no liquidity below 4,600 so we cannot create a wider set of strangles. The strangle payoff ratios also suggests that on balance, it's better to take a view and go with either a bull spread or a bear spread but not both positions. The bull spread has the better risk-payoff ratios so I would stick my neck out and go with that.

Stock Futures/Options

In the stock F&O section, forget about the options. There's no liquidity to speak of. Even in the futures market, stay within the narrow compass of the top 10 contracts and the 10 most liquid underlyings. Keep plenty of margin in reserve if you are holding overnights.

One interesting possibility is Reliance Capital, which could respond positively to the buyback. There was strong positive action in the cash (close: 1,388) and futures market (1,382) and a climb till the 1,475 level is quite likely. Go long here with a stop at 1,370.

The banking sector is also interesting. The Bank Nifty has been hit very hard and there were signs of short-covering towards Friday's close. SBI is one counter (cash: 1,831/ futures 1,839) where the trend is likely to have reversed at least temporarily. It has a possible upside till around 1,910. Keep a stop at 1,820 and go long.