Volume expansion required for breakouts.
Low volatility and very low volumes distinguished derivatives trading last week. Open interest was also low and many positions were extinguished on Friday.
Index strategies
This is the third successive week of low volatility and it is very unusual since this period encompassed a key settlement. Trading volumes fell below Rs 50,000 crore on Friday, which is almost half normal F&O levels. Open interest (OI) dropped in Nifty futures with many positions settled. A part explanation is low FII participation. While FIIs have bought Rs 3,000 crore (net), their derivatives exposure amounts to 34 per cent of all OI. It is normally closer to 38 per cent and that is when volumes and OI are much higher. The Vix has dropped but not as much as recent historical volatility would lead one to expect. However, option premiums are fairly low.
Directionality is very difficult to predict, given that the index has seen daily high-low ranges of 1 per cent or less. Technical analysis suggests it is likely to shuttle between 5,150 and 5,300 until volumes expand considerably. Given Friday's weak close, the Nifty could fall another 100 points before it bounces. As and when there is a breakout, we will see a spike in volatility as well. The projected target in case of a breakout would be between 4,950-5,050 on the downside and 5,400-5,450 on the upside. Rupee strengthening and liquidity will influence direction. The rupee is up about 2 per cent in 2010 and yields on interest rate futures have dropped slightly. The rise has impacted the CNXIT severely. Perhaps Infosys and TCS will deliver quality results and good guidance to turn this trend around.
The Bank Nifty on the other hand, has responded well to slightly easier liquidity and it is likely to outperform the Nifty. Between them, the Bank Nifty and CNXIT have considerable influence on the Nifty. If they are moving in opposite directions, the net effect largely cancels. Hence, we may need a situation of trend-coincidence in these two indices before there can be a serious Nifty breakout.
Looking at Nifty option statistics, there are also no clear indicators as to direction. About 55 per cent of OI is in January. This is likely to rise if F&O volumes climb. The put-call ratio (PCR) in terms of OI is around 1.2, which is in the normal zone and mildly bullish. The PCR for January is around 1.4, which is also in the normal-bullish zone. The January option chains show expectations are narrow. The put chain has maximum OI clustered at 5,000p (premium 30) with high OI also at 5,100p (49) and 5,200p (80). The call chain has maximum OI at 5,300c (74) with some OI at 5,200c (127) and 5,400c (38).
There are three possible strategies for option traders. One is to stay close to money with conventional spreads. This offers good risk-return ratios because premiums are low at the moment but the trader may have to take a call on direction.
A second strategy is to look for big breakouts via strangles, or via far from money spreads. This offers excellent risk-return ratios but the probability of success is lower. The third possibility is to assume volatility will not rise and either use long butterflies or short-long strangle combinations, selling options closer to money. Option selling carries the risk of high loss if there is a breakout.
The simple CTM bullspread of long 5,300c and short 5,400c costs 36 and pays a maximum 64. The CTM bearspread of long 5,200p and short 5,100p costs 31 and pays a maximum of 69. Excellent risk-reward ratios if you can take the right call on direction.
A combination of these two is a long (5,200p+5,300c) strangle and a short (5,100p+5,400c) strangle with an initial cost of 67 and a maximum one-way return of 33. If the Nifty moves between 5,100 and 5,400, the total return will be around 133. This is reasonable with breakevens at 5,133, 5,367.
A wider set of strangles like long 5,400c (38) and long 5,100p (49) versus short 4,900p (17) and short 5,600c (6) costs a net 64 and pays a maximum of 136 on a one-way move with breakevens at 5,036, 5,464. If the market moves between 4,900 and 5,600, the return would be about 336. The return-risk ratio is good but it works only if there is a big breakout.
The reverse of this position (short 5,400c+short 5,100p; long 4,900p+long 5,600c) offers adverse risk-return ratios, but it works if there isn't a breakout. Another low volatility play is a long put butterfly. A long 5,300p (126), two short 5,200p (2x80) and long 5,100p (49) would cost an initial 15 and that is the maximum loss (net of commissions). The butterfly pays a maximum of 85 at 5,200, and the breakevens are 5,115, 5,285. Right now, it is about 40 in the money.
The butterfly offers potentially higher profits and limits losses compared to the short-long strangle combination. However, if the market does stay within 5,100-5,400, the butterfly will outscore the short-long strangle combination only between 5,180 and 5,220.
| STOCK FUTURES/OPTIONS Quite a few sectors could offer potential long positions. One is real estate, where DLF and Unitech are both looking good. Another is shipping, where GE Shipping and Aban Offshore are bullish. Engineering and construction is also worth looking at if you are bullish with prospective long positions in counters like HCC, GMR Infra and L&T. On the short side, Infosys, Wipro and other IT majors are potential plays. The auto sector has seen sell offs last week and Maruti for instance, could be close to a reversal and a long position here could also be contemplated. |
