Go for bear spreads

DERIVATIVES

With the Nifty trading around 1853 and two weeks to go for settlement, matters are interestingly poised. Technically the market looks quite likely to stay bound roughly between the range of Nifty 1825-1900 in the immediate future.

However, as I mentioned elsewhere, every general election seems to spark a downtrend while polling is in progress. That downtrend is usually followed by an uptrend in the first month after polling is completed. If that pattern holds, April should end weak and the market should only start picking up in mid-May.

In these circumstances, a calendar bear-spread looks interesting. If we sell April Nifty (1857 on Thursday), and buy May Nifty (1860) we are trading on the expectancy of either April futures dropping in price, or May futures appreciating. If either of these events occurs, and the gap between the two months widens, this trade would do well.

Options instruments offer more latitude in terms of building trading positions. If we assume that the market will move further away from current prices, we should build long straddles and strangles. If we assume that prices will dip in April, only to recover in May, we should assume bear-spreads for April instruments and bull-spreads for May instruments.

Unfortunately the second set is not easy to completely execute because May instruments are still illiquid and the cost of carry is excessive. But bear this in mind when the settlement day comes along and consider going with bear-spreads at the moment.

Unfortunately implied volatilities seem to be discounting the possibility of big moves since premiums are rather high. Let us say, we take a long strangle consisting of long 1870c (37) and long 1830p (29). This straddle costs 66 and it will be profitable only if the market lands outside the range of 1765-1935.

A straddle of a long 1850c + long 1850p (46+37) costs 83 and would be profitable outside roughly the same range of 1765-1935. If we sell the straddle and buy the strangle, we are left with 17 in terms of premium inflows at a spot of 1850. However the profit of the combined function deteriorates rapidly and goes into losses outside the range of 1840-1860.

It may be a better trade to sell a short strangle close to the money. Suppose we go with a short 1860c + short 1850p (41+37), the initial return is lower in terms of premium inflow of 78. This combination gains if the market moves up but it loses if the market drops below 1840. That's too dangerous.

We could try taking a very-far-from-money long strangle such as long 1770p (13) and long 1940c (12) versus a short straddle at 1850. The combined position would have an initial premium inflow of 58 at 1850. It would stay profitable if the market remained within the range of 1800-1900. Losses would be capped at a maximum of 32. However, there's still a fairly high risk with such a position given the election factor.

Simple bear-spreads seem to work fairly well. Since we do expect a fairly large movement, we can afford to take positions away from the money. We can also try to create call-based bear spreads accepting premium versus the risk of a large upside move.

A straightforward bear-spread such as long 1850p (37) versus short 1830p (29) costs 8 and it could pay a maximum of 12. A wider bear-spread of long 1830p (29) versus 1810p (22) costs 7 and could pay a maximum of 13. The marginally better risk-reward ratio is balanced against the lesser likelihood of the position being hit. So, if you wish to create put-based bear-spreads, you may as well be close to the money.

A call-based bear-spread close to the money would be dangerous though the risk-reward ratios are not bad. Say, we shorted 1860c (41) and bought 1880c (32). We would receive 9 and risk losing a maximum of 11. Suppose we sold short 1880c (32) and bought long 1900c (24). Now we receive only 8 and risk a maximum of 12 but the adverse ratio may be compensated by the unlikeliness of the position being struck. As can be seen, the put-based spread has a better payoff.

Among stocks, by and large, there seem to be very few scrips that are likely to perform in a manner different from the general market. It may be worth buying May oil PSU futures since these look likely to outperform as a sector. Most of the PSU banks also look to possess underlying bullishness. So these May futures could also be a buy.

Apart from that, Ranbaxy, NIIT, Reliance and Tisco are possible hedges against a market downturn in the next two weeks. Of these, the risk-reward ratios available in NIIT and Ranbaxy are not very satisfactory because of lack of liquidity in instruments above the spot prices.

NIIT is soon likely to develop a lot of liquidity in calls above 200 level. A long 200c (10) versus a short 210 c (4) would currently have a return of just 4 versus an outlay of 6. However, there is an open interest (OI) of only about 3000 in the 210 c and that is likely to see premium and volume appreciation soon. Buy a naked 200c and sell 210c once liquidity improves and the premium appreciates.

Ranbaxy has seen a spurt till the 1040 level and a long 1040c is available for about 23. Buy 1040c (23) and sell 1060 c (14) for an outlay of 9 and potential returns of upto 11. In Reliance, a long 580c (12.5) versus short 600c (6.25) costs 6.25 and it could pay a maximum of 13.75. In Tisco, a long 410c (11) versus a short 430c (5) costs 6 and it could pay a maximum of 14.