Set up bear spreads

DERIVATIVES

The market is likely to remain stuck inside a narrow range in the short-term but it is also showing signs of moving up in the intermediate term. Liquidity in options around the money seems to be adequate and open interest (OI) has built up in August futures.

The Nifty put-call ratio (PCR) has moved up but at 0.4, it is still in neutral territory. September Nifty futures are at a very small discount to the August Nifty, which is trading at the same levels as the spot Nifty.

In the index futures segment, a long August Nifty seems a fair trade. So does a calendar spread involving selling the August Nifty and buying the September Nifty. However, the profit from either of these trades is likely to be small - there isn't much of a differential.

Perhaps it makes sense to wait until the settlement week before making a calendar spread - this would piggybank on the expected shift of long positions to the next month's equivalent long positions.

The market position appears to be such that bull spreads are likely to be more profitable over the long term. However, in the context of the next few sessions, we don't expect an upmove.

The Nifty is trading at around 1633 and we expect it to stay rangebound within the bounds of 1600-1650 over the next five sessions. A trader could try to set up bear-spreads in the short term and bull-spreads for the longer term.

First let's look at straddles and strangles. A long 1630c (33) plus a long 1630p (30) costs 63. This straddle would be profitable only outside approximately 1565-1695. We could sell this position assuming that a long strangle could be found to provide appropriate cover.

If we sell this position (short 1630p + short 1630c), we get 63 in premium. A long 1660c (19) plus a long 1600p (18) costs 37 and it would offer cover outside 1563-1697, which is about the same range. The net premium accrual is around 26.

The profit function suggests that this position would be profitable only inside the 1600-1650 range. If you decide to take this combination of short straddle and long strangle, try and reverse both positions at favourable premiums rather than hold till settlement.

In terms of conventional bull spreads, call-based spreads offer reasonable risk-return ratios. But the trader would have to take wide positions which involve putting fairly large premiums down and carry them for a longer period.

A long 1640c (28) versus short 1660c (19) costs 9 and offers a maximum return of 11. A wider position with long 1640c (28) versus short 1670c (16.5) costs 11.5 and it could pay a maximum of 18.5. Such a spread would probably have to be held over a long period in order to extract the maximum return.

It's dangerous to take put-based bull spreads. The market carries the risk of trending down until the 1600 level at least and anywhere above the 1600 level, a put-seller would carry unacceptable risks.

The other possibility is to create positions that are minimally profitable and at poor risk-return ratios because they are very far from the money.

If we sell the 1600p (18) and buy the 1580p (12), for instance, the position would pay an initial premium of 6 and could involve a potential loss of 14.

If the trader happens to be bearish about the current market trend, he needs to examine bear spreads. These have decent risk-return ratios so they are tempting.

A position like long 1620p (25) versus short 1600p (18) costs 7 and it could pay a maximum of 13. A wider position like long 1620p (25) versus 1590p (15.25) costs 9.75 and it could pay a maximum of 21.25.

In terms of individual stocks, Maruti looks like an interesting short. The stock has seen a selloff in the last couple of sessions. The trader could try to sell the August Maruti future (402), which is trading at a small premium to the spot (400). Alternatively, a bear-spread like long 390p (10.5) versus short 380p (7) is possible. This would cost 3.5 and pay a potential maximum of 6.5.

Associated Cement Companies (ACC) and Gujarat Ambuja Cements appear to be excellent buys. The August future of ACC is at a small premium to the spot price while the Gujarat Ambuja Cements future is running at a small discount to spot.

But they are still worth buying. Apart from long futures, option bull spreads are possible. In ACC, a position with a long 260c (7) and a short 270c (3.5) offers a good risk-return ratio with an initial outlay of 3.5 for a potential return of upto 6.5. In Gujarat Ambuja Cements, a long 310c (7.65) versus a short 320c (4) costs 3.65 and it could payoff to a maximum of 6.35.

Hindustan Lever has lost a lot of ground in the recent past following disappointing results. It may have hit a level where it could find support. This could really be a long-term delivery based buy rather than a short-term options play.

However, the ratios in the F&O segment look good to an optimist. The HLL August future (114) is at a small discount to the spot price (116). A trader could buy the future or buy a long 120c (2.1) and sell the 125c (1.1), paying 1 for the possibility of gaining upto 4.