High volatility, high carryover

While the risk:return ratios are identical for both spreads, favour the bearspreads in line with the bearish signals in the market.

The market-wide sell off on Friday compounded an already weak trend. The effect on the derivatives markets was that volatility rose in choppy trading. However, carryover was excellent and settlement week could be high-volume.

Index strategies
The settlement week is likely to see high volatility. The market may swing through a range of 350-400 points with at least one massive session. The short-term signals (May contracts) are bearish but the June scenario is reasonably positive.

The past two settlements have seen weak carryover and low volume-low volatility settlement weeks. This time around, the VIX has risen to 34, which is a dramatic change from the low 20s of the recent past. That's a bearish signal.

As to carryover, roughly one-third of Nifty futures open interest and close to 40 per cent of Nifty option OI is already in June and July instruments. This is a strong trend and it's been driven by Indian traders. The FIIs have not been particularly active since they hold around 40 per cent of OI, which is par for the course.

There is an asymmetry in the options market, which is worth commenting on. A lot of May Nifty puts have been settled in the last couple of sessions. The May Nifty put-call ratio is down to 1 in terms of OI and verges on the overbought. However, the overall Nifty PCR (OI) is at 1.37, which is normal and the June-July OI is 2, which is not very high for this stage of settlement.

The high proportion of outstanding mid and far contracts masks weakness in the near month. Two weak signals are backed by a third. The put option chain has a dramatic drop in OI from May 4800p (19,000 contracts) to 4700p (7,000 contracts). This signifies little support below 4800. If the market dips below that, it could be a big slide.

However, there is the promise of a lot of short-covering to come in the next 3-4 sessions both in the Nifty and across stock futures. There may be enough short covering ammunition to pull the market back from 4800 and indeed, enough to propel it back over 5100 on an intra-day basis.

In the index futures market, the carryover has, as usual, been skewed completely in favour of Nifty. Apart from Nifty futures, where 32 per cent of outstanding contracts are in June-July, only the BankNifty has significant June OI.

There's no differential between May Nifty and June Nifty (both 4941) and the discount to spot suggests bearish expectations. In the BankNifty, spot closed at 7009.05 while May was settled at 6972 and June at 6958. Not much difference but also bearish expectations. In the CNXIT, there could be some long action in the June contract if the rupee stays weak.

The Midcaps-50 offers a potentially interesting arbitrage. The spot is 2665 while May M-50 was settled at 2631 and the June M-50 (negligible OI) at 2687. On Thursday, this could get interesting if the difference lasts. The calendar arbitrage is long May and short June but carryover enthusiasts would do exactly the opposite. Unfortunately, liquidity is very low and we wouldn't expect more than 15-20 contracts to be carried forward (lot size:75). Look out for liquidity improvement.

In the options market, a lot of traders are moving into June instruments. While these are more expensive, they do allow the creation of wide spread without fear of expiry. If you prefer to go with the cheap May options and risk expiry, stay close to the money.

In CTM May contracts, a bullspread such as long 5000c (36.5) and short 5100c (13) offers a maximum return of 76 on an investment of 24. A CTM bearspread with long May 4900p (52.45) and short 4800p (28.2) also costs 24 and offers a return of 76. The risk:return ratios are identical and both spreads have a fair chance of being struck despite the expiry factor. The bearish signals lead us to favour the bearspread.

Wider spreads, if any should be taken in June. A long 5100c (105.35) and short 5300c (43.25) costs 62 and pays a maximum of 138. A long 4800p (136.8) and short 4600p (77.9) costs 59 and pays a maximum of 141. The risk:return ratios are almost the same and one of these spreads will be hit if a breakout occurs by June 26. If you want a better sense of direction and lower premiums, wait till Tuesday.

Summing up, if you want to trade on Monday or Tuesday, you may as well take a CTM May spread and technical signals suggest the bearspread is more likely to work. If you want a wider spread in June options, wait till Tuesday for better prices and, with luck, a clearer sense of direction.

STOCK FUTURES/ OPTIONS

Old-timer traders say ''Don't buck the trend'' and that is currently down. But short-covering in the next 3-4 sessions is guaranteed by settlement compulsions. This is going to mean sharp swings in stocks that are first sold down and then bought back within a very tight schedule.

SBI is an interesting possibility. The May futures was settled at 1550 while the cash closed at 1573. Arbitrageurs will sell the cash and buy the future to lessen differential but the trend is likely to stay bearish until support is hit at around 1490-1500. Short-covering and carryover on Wednesday-Thursday is liable to push it back till 1600. Try selling May SBIN on Monday and buy June SBIN on Wednesday.