Markets are stuck in the 2,500-3,100 range. Directional calls are difficult to make in range-trading breakouts
Two weeks of low volume, low volatility trading could be the prelude to a breakout that wrong-foots the unwary. This is a near-ideal situation for traders who play trends in both directions.
Index strategies
The textbooks say derivatives are often a play on volatility. The narrow range-trading patterns we have seen in the past few weeks could be a good practical situation for volatility watchers to take action.
The Nifty has been stuck inside a 100-150 point range of 2,750-2,900 for two weeks. Any breakout will lead to a 200-250 point move. Based on normal behaviour, this range trading cannot last much longer. Once there is a breakout, volatility will rise sharply and volumes are also likely to rise as trend watchers commit themselves.
Directional predictions are difficult to make in range-trading breakouts. The market has traded extensively between 2,500-3,100 in the past few months. There are many bearish signals such as poor breadth and poor volumes.
There are also a few bullish signals such as lower inflation, lower spreads in government securities and less institutional selling. Chart patterns suggest that most major stocks have made bottoms on reliable support and some are seeing selective investment.
Index futures are all at some discount to respective underlyings, which is mildly bearish. The BankNifty shows signs of mild bullishness due to speculative action taken by traders who expect another rate cut. The CNXIT looks neutral. Even the rupee has been trading in a narrow range. The Vix has been stuck between 40-50 levels for the past couple of weeks but its behaviour is not a reliable predictor of direction.
The put-call ratios seem quite healthy. In terms of OI, the Nifty PCR overall is at 1.2 with the February PCR at 1.25. There is about 42 per cent of option open interest (OI) in March and beyond. There is a fair amount of OI in the June 2009 2,300P at a premium of 134, which suggests “pessimists” expect a fall till 2,150 or thereabouts. There’s much less volume in long-term calls but the June 2009 2,800C has a premium of 325, which means “optimists” are expecting 3,150 values.
These June 2009 breakevens are close to the current price. Given the Nifty’s historic patterns, I suspect that many traders have been lulled into false expectations of low volatility. As and when there is a breakout, premiums are liable to jump in the direction of the trend (calls if it’s upwards or puts if it’s down) and there will be a hasty realignment of trading views.
Classically, this is a situation where traders should either try and cover both directions or gamble on no breakouts. If you think a breakout will occur, buy close-to-money (CTM) because premiums are underpriced in cases of rising volatility. Sell CTM if you think a breakout is unlikely.
Either way, straddles and strangles are the ideal tools. We can explain this logically by starting with simple spreads. CTM bullspreads such as a long 2,900c (73) and a short 3,000c (38) costs around 35 and pays a maximum of 65. A CTM bearspread such as long 2,800p (96) and short 2,700p (61) also costs 35 and pays a maximum of 65.
The risk-reward ratios are excellent for either direction for these simple spreads. Incidentally, the higher put premiums probably indicate that consensus expectations are bearish as indeed do the higher volumes in long-term puts.
Both these positions could be easily hit, and if we combined them, the net cost would be 70 and the maximum return would be 30 in either direction. However, we can and should go wider to create strangles.
For example, a long 2,700p and a long 3,000c cost a total of about 100. If this is laid off with a short 2,500p (25) and a short 3,200c (8), the net cost drops to 67. In that case, the long-short strangle combination has breakevens at 2,633 and 3,067. The maximum return on a breakout in either direction would be 133. This is a pretty decent risk-reward ratio and this position seems worth taking on the chance of a breakout.
However, if you believe that the market will stay locked inside 2,700-3,000 until the end of the February settlement, you could take the reverse position. That is, take a short 2,700p and a short 3,000p to pick up the premium of 67.
But the risk-reward ratio is adverse and the odds are against the Nifty staying locked inside a range of less than 5 per cent for three more weeks. Any trigger of some description could create a trend and three weeks rarely passes without a trigger.
My gut feel is that the market is more likely to go up than down because there should be a rate cut. Balanced against this, there could also be a terrorist attack or some adverse political development or more Satyam-type revelations. It is really safest to stay hedged in both directions.
| STOCK FUTURES/ OPTIONS As mentioned above, more pivotals are looking bullish than bearish. Real estate and steel are the two sectors, which look most likely to see sharp upturns with some bullish potential in other rate-sensitives like infrastructure and banks. This would be a typical bear-market rally if it occurs – that is, prices would rise sharply and decline equally suddenly once the trend is exhausted. Among the above, GMR Infrastructure, Brigade, Purvankara and NTPC all seem to be bullish. But SAIL seems to have a strong and clearly established trend, which has occurred due to rising steel prices on LME. Keep a stop at Rs 83 and go long. |
