Look for November bear-spreads

DERIVATIVES

Expect a bout of an uptrend next week due to short-covering, but the undercurrent is weak.

The extreme volatility we saw this week is likely to continue into the settlement. The new participatory note (PN) regulations will come into force after that so the foreign institutional investors (FIIs) will have hard decisions to take in terms of carryovers. Since their outstandings constitute roughly 36 per cent of all trades, their decisions will obviously be crucial.

Index strategies
The PN regulation more or less guarantees a fall in liquidity in the near"�term across the F&O markets. Essentially about $30 billion worth of PN-based derivative positions will have to be liquidated within the next 18 months.

While that may seem a generous timeframe, the bulk is likely to shift out soon. It may travel back later through other routes but the initial impact will be loss of liquidity.

Therefore, be prepared for the November settlement to register considerably lower volumes and open interest. In turn, that could mean higher margins "� anyway a trend of rising volatility is likely to prompt that.

The trend across both cash and futures market is clearly bearish. However there is likely to be short-covering on at least one session of this settlement. That could mean a sharp upward technical correction that punctuates a broader downtrend.

The spot Nifty closed at 5,215 while the October contract was held at 5,193, November was held at 5,174 and December at 5173. open interest shrunk by 18.8 lakh in the October futures but it expanded even more in November (25.9 lakh). However the FII component of index futures shrank overall while index options expanded slightly.

The premium of spot to future is unusually high for this stage of settlement and emphasises the bearish sentiment. The 19 point difference between October-November can be exploited with a short October, long November calendar spread. But this is a full margin position in the last week of trading.

Among other indices, the CNX-IT is at 4,847.60 in the October futures and at 4,894 in spot. A case can be made for a naked long position since the rupee will drop on a mass FII exit.

The BankNifty is at 7,409.75 in October, 7,445.8 in November and at 7,424 in spot. Open interest dropped in the October contract and expanded only marginally in November. But liquidity is just about adequate.

The difference can be exploited through a long October- short November. A naked short November also makes sense since the financial sector has been hit very hard "� it is FII-sensitive.

The Nifty Junior is the most interesting. It lost 9 per cent in the spot market to close at 9,116. The October contract is 9,101.20 while November is almost illiquid and sitting at 9,197. It will be difficult to lock the difference due to lack of liquidity.

My gut-feel is that the short-covering, as and when it occurs, will be most beneficial to the Junior. A gambler could risk a naked long October in the Junior and perhaps take a short November as the liquidity improves.

In the options market, the put-call ratio in terms of outstanding Nifty options dropped to 1.1, which is on the verge of bearish. Many new calls were opened while puts were cashed and put open interest fell.

The FIIs incidentally have increased their index options exposure slightly. In terms of carryover, the open interest of both put and call index options has increased in the November segment along with index futures open interest.

A trader will have to be oriented to an index which could easily swing 200 points every day and anywhere in the range of 4,800-5,700 in the settlement week. Using the long October 5,250c (117) and short 5,350c (85.5) the resulting bull-spread would costs 32 and pay a maximum of 68. Using October long 5200p (145.3) and short 5,100p (105.65), the position costs about 40 and pays a maximum of 60.

These are reasonable return ratios and both are extremely likely to be hit but the expiry factor makes them more risky than one would like.

If we use November long 5,300c (250) and short 5,400c (226.6) the premiums might make you gulp. But the resulting position costs 23 and offers a maximum payoff of 77. It could be hit next week itself or in the next upswing. The only worry is that these premiums may not hold.

A November bear-spread of long 5,200p (319) and short 5,100p (286.35) costs 33 and pays a maximum of 67. Again the premiums are higher than normal but this is likely to be a feature of the entire market until the PN situation is resolved.

My instinct would be that bear-spreads are worth taking in November options. However if you want a bull-spread, take it in the October settlement. Any uptrend caused by short-covering is much more likely to occur next week than next month.

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STOCK FUTURES/OPTIONS

The stock F&O market is likely to mainly see likely losers. There is pressure on the entire universe of financial stocks. The Reliance and ADA group stocks are also likely to see sell-offs sustained through next week. Tata Steel is another counter that could see bearish action.

But the pick of the shorts could be IFCI. That has seen rampant speculation over the past few months and it could now see frantic exits. Technically, a fall till the 65 level looks quite possible.

On the upside, we've mentioned Triveni as a possibility in the cash segment. The other two potential long positions are Powergrid and GMR. The Powergrid IPO was obviously very attractively- priced, given gains of 160 per cent since listing. GMR has taken a hammering post-split and may be due to bounce. It could go back till the 160-165 level.