Option premiums continue to rise

DERIVATIVES

The bear spreads offer marginally better risk-reward ratio than bull spreads.

All the signals suggest that November will be a most dangerous settlement. We are seeing high price-velocity coupled to lower derivative trading volumes. This could cause major upheavals if unhedged traders are caught on the wrong side of a big move.

Index strategies
After Sebi's clarifications on participatory notes, FIIs have held their ground in futures and options while continuing to buy heavily in cash. However Indian operator volume is clearly down. In absolute terms, FII trading volumes are also a little down but the open interest held by FIIs has increased across most F&O segments.

While the market continues to rise, there is always the chance that operator volume will ease back in now that the FIIs are out of panic mode. However, if the market falls, there would be a rapid unwinding of positions and a spike in margins and option premiums.

The star of the past fortnight has been the Bank Nifty, which has gained over 26 per cent in that period. The bank rally has exerted a big influence on both Nifty and Nifty Junior. It appears to be the driving force at this instant but post-Credit Policy, financial stocks are likely to lose some momentum.

In terms of differentials, there are no meaningful arbitrage positions available in index futures. November is a long settlement so the cost of carry would be significantly higher than the minor differentials available.

The Nifty closed at 5932 on Friday in the spot market while the November and December futures contracts were settled at 5956 and 5940 respectively with January settled at 5933.

Open interest expanded in all three periods. Settlement comes on November 29 and the November-December difference is not yet worth trading though a short November and long December calendar spread would lock in some gains.

Among other indices, the Nifty Junior closed at 10598 with the November contract settled at 10630.55. The Bank Nifty closed at 9561 in spot with November settled at 9563. The CNX IT lost ground and closed at 4745 with the November contract held at 4742. There was no liquidity in mid-term or far contracts hence, no question of calendar spreads.

Both Infosys and TCS appear capable of a short rally so there is a small case for going long in the CNX IT. The premium on the Junior suggests bullish expectations while the lack of premium on the Bank Nifty could mean that the momentum has slowed.

Unsurprisingly premiums have spiked in the Nifty options market. However, somewhat surprisingly given the strong uptrend, there is liquidity in the option chain until 6150 which is well above current trading levels.

Last week, the Nifty put-call ratio in terms of open interest stayed in the 1.17 range, which is nearly unchanged from previous weeks. However the put open interest expanded on Friday while call open interest dropped, presumably as winning positions were cashed out.

In the past fortnight, the Nifty has moved an average of 3.2 per cent per session in terms of its high-low range as a percent of close. That's roughly a 180 point swing per sessions. The smallest swing was 1.6 per cent. If this trend holds, you are guaranteed a minimum 100-point range per day.

This gives a crude rule of thumb for judging implied volatility of option premiums versus historical volatility. Implied volatility is slightly higher than historical volatility "� the near-to-money 5950c costs 218 and 5900p costs 195. In theory, one should be aiming to sell options in this situation but the margins will be high and you will have to sell far from money for safety.

Our target range for the next week's trading is anywhere between 5500-6300 with a near guarantee that the market will swing between 5700-6100 at the least. It would hit 5700 if there was one bearish session; it would hit 6100 given one bullish session.

A bear spread of long 5900p (195) versus short 5800p (155) costs 40 and pays a maximum of 60. A bull spread of long 6000c (193) versus short 6100c (147) costs 46 and pays a maximum of 54. The bear spreads offer marginally better risk:reward ratios.

A strangle of long 5900p and long 6000c costs 388 and hits breakeven if the Nifty moves outside 5500-6400. This cannot be fully laid off. While a short 5500p (82.25) is available, there is no liquidity above 6150c (122). The risk:reward ratios don't seem to work.

If you wish to sell options to exploit the high IV, you can only look for a put-based position. A short 5700p (125) versus long 5600p (102) fetches 23 and could lose a maximum 77. This position will be triggered adversely if there are two losing sessions.

If you can hold it, it probably makes more sense to take the long 5700p versus short 5600p bear spread rather a reversed bull spread. The risk:reward ratio is good and the position will pay off if there's a decline any time in the settlement.

STOCK FUTURES/ OPTIONS

The loss of liquidity has been felt most keenly in stock futures where operators and traders are usually thick on the ground.

While the top stocks are still generating plenty of open interest, the less popular counters are drying up. Even where arbitrage opportunities arise, the loss of liquidity will make them difficult to exploit.

Still there are a few interesting positions. Hero Honda could be a good short. The stock could have a downside till 640.

There is also a potential long future position available in Punj Lloyd where the stock has been testing resistance around 500 and looks poised for a breakout. If it does close above 500, a move till 535 is likely.