Go for a bear spread

DERIVATIVES

High put-call ratio and costly puts could mean that the market is ripe for a sharp bout of intraday volatility.

The market surged through the latter part of the week and the Nifty closed above the 4500 level. Open interest and trading volumes remained high and there was enthusiastic FII participation. Next week could see more gains albeit intra-day volatility is likely to rise.

Index strategies Trend-followers will be pretty happy with the current situation. The Nifty has been up for five weeks and delivered consistent gains. Until the pattern of higher peaks is broken, most people will want to stay long if they are into naked futures positions.

The Nifty closed at 4,504 in spot with the July future settled at 4,483 while the August future was settled at 4,471 and September at 4,461. There is respectable open interest in the September series.

The differentials are normal in a bullish trending market so, there is little point in a calendar spread unless you can hold till expiry. If you can do that, a long August, short July combination will lock in a little profit and you can contemplate a long September, short July as well though this is more risky.

Of the other indices, the Nifty Junior made a disproportionate gain of over 4 per cent and closed at 9,089 in spot. The July series was settled at 9,094. There is very little open interest in the August series, which was settled at 9,188.

There may be enough liquidity to make a calendar spread possible and this could be very profitable if you go short August and long July. The premium on the August contract with respect to July must drop before settlement.

Of the sector indices, the CNX IT lost ground. It's at 5,185 in both spot and the July series. If TCS also produces bearish results, then the CNX IT is liable to see more pressure.

There is a case for going short here. The Bank Nifty closed at 6,980 in spot and it was settled at 6,988 in the July series. There is selective buying across the bank sector and this is likely to continue until all the FPOs are over and done with, months down the line. Hence, a long position is possible.

In the options market, the strong uptrend has led to the usual problem of lack of liquidity at the upper end of the option chain. There are no quotes for calls above Nifty 4,500. In fact, open interest has dipped in the calls segment as profits have been booked. The put-call ratio (PCR) for outstanding Nifty options is now at 1.84, which is well above normal.

A high PCR is usually a bullish signal but a very high PCR can mean that the market is ripe for a sharp bout of intra-day volatility and/or profit-booking. In addition, premiums have gone asymmetric with puts being priced much higher than calls. By and large, the implied volatility close to money is lower than historical volatility "� this is also normal in a big bull run.

Our technical view is that the market has a possible upside till 4,575 and a downside till at least 4,425. It's impossible to create call-based bull spreads. A long 4,500c (48.85) is in-the-money and it will pay off the market moves past 4,550. It's possible to take a naked call and lay it off with a short 4,550c as and when liquidity develops.

One way to take a bull spread is a far-from-money position like short 4,400p (33) and long 4,350p (25). This is risky as it could be struck and it offers an adverse risk-reward ratio of 8 in net premium versus a potential maximum loss of 42.

Bear spreads are much easier to create and price. A long 4,500p (65.65) versus short 4,450p (45.65) costs 20 and pays a maximum of 30. This is a decent risk-reward ratio and it is very likely to be struck within the next 3 sessions. So the bear spread seems like a better strategy.

A long straddle at 4,500 costs about 115 and it hits breakeven if the market moves beyond either 4,615 or 3,885. There are nine sessions till settlement and either side of this position could be hit though the upside looks less likely. The position can be laid off only on the downside with say, a short 4,350p (25).

That would reduce the cost of a long straddle to about 90 and breakeven would come outside about 4,410-4,590. The downside payoff would be a maximum of about 60. Reversing to take a short straddle looks dangerous "� as mentioned above, the implied volatility is on the low side.

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STOCK FUTURES/ OPTIONS

One is tempted to suggest that traders should short available IT counters like TCS, Satyam, Polaris and Wipro. But TCS is signalling the likelihood of massive volatility, which means a possible upside also exists. A safer short may be GMR Infra, which is finally reacting after a sustained rise.

There is a possible downside here till 855. Several sectors could produce profitable long positions. One is metals "� there have been jumps in Tata Steel, Sail, Hindalco and Sterlite.

Another possible is the auto sector "� M&M, Tata Motors and Maruti are all looking good. There is also bullish action in cement stocks apart from Gujarat Ambuja, which has not moved much.