Premiums are low compared to volatility

As the Nifty hit a six-month low and bounced, volatility rose in the derivatives market. Trading volumes also rose somewhat and the signs of greater liquidity in mid-month Nifty contracts suggested that carryover into April has started.

Index strategies

Trading volumes are still well below the Rs 55,000 crore a day levels the market has been accustomed to since 2007, but there is improvement over the drought of the past six weeks. The Nifty has been swinging by around 150 points per session and that has probably dragged more players into the derivatives market. However, the foreign institutional investors (FIIs) still hold the whip-hand with an overwhelming 45 per cent of all futures and options (F&O) outstanding positions.

With two weeks to go for settlement, there is now some liquidity in mid- and far-month Nifty contracts. The long-term market sentiment is clearly bearish. However, there could be a continued bounce in the early part of the coming week. The Nifty is at mid-point in a clearly defined trading range.

In the index derivatives market, open interest and liquidity for instruments other than the Nifty remained at a premium. The Nifty itself closed at 4,746 on Friday with the March contract settled at 4,746.95, April at 4,729.45 and May at 4,705.15. There was a sharp 22 lakh decline in open interest in March contracts but around 4.5 lakh new positions were added to April-May open interest. A calendar spread is of long April-short March looks just about profitable.

Among other indices, the Junior closed at 8,209.75, while the March contract was settled at 8,248.50. The Bank Nifty closed at 7,106 while the March contract was at 7,108.60 and April at 7,200.00 (only 1,200 open interest). The Nifty Midcap 50 closed at 2,440.55 while the March contract was settled at 2,449.10. The CNX IT closed at 3,530.7 while the March contract was held at 3,542.75.

The lack of liquidity in mid- and far- contracts is disturbing but the fact that all near-term index futures are trading at a slight premium to spot is an encouraging signal for the short-term. There isn't really an arbitrage position available anywhere but the chances are the market will rise at least another 100-odd Nifty points.

In technical terms, the Nifty is likely to bounce between support around 4,600 and resistance at 4,900 and its midway between those two levels. Apart from chart patterns, outstanding open interest in the 4,600 put and the 4,900 call suggest that these levels are defining. There is no support below 4,500 in terms of liquidity.

In the Nifty options segment, there are interesting patterns to the put-call ratio (PCR). Both put and call open interest expanded last week but more calls were created. In terms of open interest, the overall PCR was at 0.92 while the March PCR was at 0.87.

The mid- and far-month contracts clubbed together had a PCR of about 1.5. Any PCR of lower than 1 is considered overbought and the market rarely hits ratios as low as 0.87. So this is a bearish signal. However, it conflicts with other, mildly bullish signals.

The only interpretation that I can come up with is that there will be a very sharp slide back to 4,600 levels once resistance is hit close to 4,900. Another point- this sort of extreme PCR build-up could trigger an extraordinarily volatile, high-volume session where the market swings by 250-points or more.

So, be prepared to fork out extra margin if you're holding index futures. Not too much can be read into mid-far month PCRs since these tend to be on the high side anyhow.

In terms of option spreads, if you stay close to money the implied volatility is on the low side considering the historic volatility. Since we expect the index to swing both ways and by around 100-150 points, either a bullish or bearish attitude could work.

A bull spread of long 4,800c (103.1) and short 4,900c (62.45) costs about 41 and pays a maximum of about 59. A decent risk-reward ratio. The equivalent bear spread with long 4,700p (110.85) and short 4,600p (76.55) costs about 35 and pays about 65 for an excellent risk-reward ratio. If the reading is correct, both these spreads could be hit this week itself.

A trader who is confident enough to hold the combined positions and book profits as and when available will probably do well. However, it is safer to stay with just the bear spread since that has somewhat better payoff ratios.

If you hold the long straddle of long 4,700p and long 4,800c, it costs about 214. Laying it off with a short straddle of short 5,000c (33.95) and a short 4,500p (52.95) earns around 88 in premium. The combined position costs 126 and breakeven arrives at about 4,574 and 4,926. The maximum return is 74 on either side of this symmetrical position. Not quite good enough to play because the market may not breakout before the settlement.

Stock Futures / Options

In the stock futures market, the focus has gone very narrow. There is little liquidity outside contracts on the top 20 underlyings. As always the Reliance and ADAG counters are generating the most buzz. RIL and RPL appear to be in maintenance or sideways mode while the most of the ADAG counters appear to have some downside.

The other big movers as a group could be realty stocks - specifically DLF could swing between 575 -750 this week, but the direction cannot be predicted. Given that the spot closed at premium to the futures' settlement price, up is the most likely direction on Monday. Another interesting counter is Axis Bank. This looks set for a sharp up move and worth a long futures position.