Calendar bull-spread makes sense

DERIVATIVES

The risk to reward ratios for bear-spreads is better than the bull-spreads.

The current rally could peter out over the next week. Settlement is around the corner; volatility remains abnormally high.

Traders will need to tread carefully especially because the rupee-dollar equation is also volatile and that could affect FII participation. The FIIs increased their F&O exposures until Wednesday, the last session for which data is available.

Index strategies
The Nifty closed at 3042.7 points on Friday in spot. The June Nifty was last settled at 3042 while July was settled at 3017 and August at 3000. There's reasonable Open Interest (OI) in all three series. June OI has seen a big drop but there's a steady build-up in July and August.

The differentials are striking at this stage of settlement, the near-month to mid-month difference is usually 10 points or less. This being so, calendar bearspreads of short June versus long July appear to be reasonable.

The differential is likely to reduce by Thursday and reversal of the position will lock in gains. A calendar spread of short July and long August is riskier since the difference may not reduce immediately.

Of the other two tradeable indices, the CNXIT has almost no liquidity in the July series and it is trading at 3793 in the June series. The spot CNXIT is held at 3803. The difference isn't much so this is probably not worth a long trade.

The Banknifty is more interestingly poised. The spot closed at 3802.5 on Friday while the June series was held at 3794 and July at 3827. That's a big premium between June-July in contrast to the discount on the Nifty. A calendar bullspread seems to make sense. A long June versus short July would work if the differential is eased by settlement.

In the Nifty options segment, the OI increased in puts and decreased in calls. Nevertheless, the put-call-ratio remained below 1""it was at about 0.89 for June Nifty options on Friday.

The PCR has risen steadily over the past three weeks. But it is still well below the "normal" readings through the bull-run between January-early May. We can't expect a rally on the basis of the PCR. If anything, there's (marginal) justification to expect a dip on this basis.

Our overall technical perspective is that the Nifty will continue to show high volatility and may swing about 6 per cent / session. The upside is probably limited to around 3200 intraday and the downside is likely to be about 2850. The spot, as mentioned above, is around 3042.

Due to the impending settlement, we would prefer to take options close to money. The high volatility would make it quite dangerous to be a naked option seller. However the expiry factor also makes it more risky to take wide positions with a long option close to money versus a short option further away. A wide position may not be fully realised.

A standard bullspread with a long 3050c (54) versus a short 3150c (21) costs 33 and pays a maximum of 67. A slightly further from money position with long 3100c (34) versus short 3200c (11) costs 23 and pays a maximum of 77.

The risk of expiry makes it less tempting however. If you wish to be conservative, a long 3050c versus short 3100c costs about 20 and pays a maximum of 30. The risk:reward for all these positions is good and we do think that the market will swing to the 3150 level at least on an intra-day basis.

A standard bearspread with long 3000p (39.25) versus short 2900p (20) costs about 19.25 and pays a maximum of over 80. This is a tempting risk:reward ratio.

A less wide bearspread with long 3000p versus short 2950p (25.5) costs about 14 and pays a maximum of 36. For that matter, an in-the-money long 3050p (55) versus short 3000p costs about 16 and pays a maximum of 34.

The risk:reward ratios for bearspreads is thus, even better than the (also good) ratios for bullspreads. Given that we expect the market to swing in both directions, the bearspreads seem to present a better bang for the buck.

STOCK FUTURES/ OPTIONS

There is little in the stock F&O segment that seems to be particularly exciting. Three stocks could exhibit the sort of volatility that traders find interesting.

One is Jet Airways where further developments on the Sahara non-merger front could lead to large fluctuations. The stock (spot 692.55) may swing anywhere between 650-760.

Although OI has been falling daily, there is still ample liquidity. We could take a long position in the June series (694). Or we could sell the future and buy the stock.

Reliance has also seen quite a bit of activity in the F&O segment (June 1013) and the stock (spot: 1012) is technically reasonably bullish. A long 1020c (18.2) versus a short 1060c (7) costs 11 and pays a maximum of 29. There's ample liquidity and the position could be fully realised though its dangerous with expiry so close.

The third possibility is in Tata Tea ( spot 754) where the stock has climbed above 750 albeit without a volume expansion. We could go long expecting a further move.

The Tata Tea June series is at 751.7 and July at 743. The differential is over 1 per cent. If we take a calendar bear-spread with short June and long July, we ought to be able to lock in some of that differential over the next four sessions.