Volatility is assured, direction less certain

Opt for the bearspread which is most likely to be struck.

Political instability, high inflation and rising crude prices all contributed to a crash. The recovery on Friday masked the bearish outcome of the four earlier sessions.

All the background indicators suggest that the market is bearish enough to be oversold. But overhangs of political uncertainty and poor macro-economic indicators remain.

Index strategies
The recovery on Friday was driven by short-covering. It started with profit-booking and that triggered a sharp rise in prices, which in turn, induced other short traders to cover. In terms of index holdings, there was substantial cashing out of in-the-money Nifty puts at 4100 strike and above.

The FIIs hold 41 per cent of all outstandings and their relative exposure to Nifty options has increased to around 35 per cent of all positions. A spike in FII Nifty option exposure is often a signal that they are intending to reverse a previously established trend. In this case, maybe they are easing off the sales.

Volatility has jumped in the past fortnight as prices moved lower. This was predicted by the VIX's earlier behaviour and indeed, the fear factor is being captured by the indicator's high readings. The fear is also reflected in T-Bill yields, which have now climbed to above 9 per cent even as the rupee has dropped below Rs 43.

The bearish sentiments are reflected in the Nifty futures which are running at very substantial discounts to the spot index levels. The July Nifty is at 3979 while August is at 3967 with the spot at 4016. A calendar spread of short July and long August is possible but it's early in a long settlement and hence, not worth taking.

The BankNifty futures (4966), the Junior (6095) and the CNXIT (3998) are all at discounts to spot levels of 4991, 6219 and 4002 respectively. The BankNifty is liable to continue underperforming the overall market in the medium-term. The CNXIT should outperform if the rupee stays weak. This is likely, given the rising trade deficit and continuing outflows of portfolio dollars.

The Nifty put-call ratio was overall at 0.76 while it was 1.1 in terms of OI and around 0.96 (OI) for July PCR. All this is on the bearish side.

Interestingly, put OI increased substantially overall by about 20 lakhs but there was cashing out close to the money in Nifty puts. In Nifty calls, over 4 lakh July contracts were extinguished, much of it in desperate circumstances. The PCR levels are bearish but the ratio has improved considerably from earlier in the week.

Over 36 per cent of puts are outstanding in non-July contracts, with a substantial proportion of these locked in December 2008 contracts. About 73 per cent of call OI is in July and again, December 2008 holds substantial call OI.

These numbers are too high to be a statistical anomaly. Such long-term positions must be hedges held by long-term players who are hoping to protect either substantial equity holdings (in the case of the puts) or primary long positions in the commodity markets (in case of the calls).

There's over 12 lakh OI in the Dec-2008 5000c (80) and 11lakh OI in the Dec-2008 4100p (435). That gives us a long-term perspective of where the smart money thinks the market could go in the next 6 months.

The option chain suggests that there will be a lot of support at 3700, and at 3800 and a lot of resistance at 4200 and 4300. The trader should probably expect moves between 3700-4300. The intra-day volatility is likely to remain consistently high with distinct chances of 200-point high-low differences per session. Premiums reflect those expectations being quite expensive close to the money.

One advantage of high volatility is that we can afford to look at wider spreads. There are three weeks left to settlement, which is ample time. A bullspread of long 4100c (119.5) and short 4300c (55.5) costs 64 and pays a maximum of 136. A bearspread of long 4000p (185) and short 3800p (109) costs 76 and pays a maximum of 124.

The bearspread is much closer to the money which makes the two positions roughly equivalent in terms of risk:reward. The bearspread is also significantly more likely to be struck and fully realised.

It does make sense to examine potential strangles in a volatile market. Say a long 3900p (144) and long 4200c (83) costs a total of 227. This can be laid off with a short 3700p (81) and a short 4400c (36) to bring the net cost of the long-short strangle combination down to 110.

The resulting position breaks even if the market moves beyond 3790-4310. The maximum possible payoff if there's a breakout on either side is about 90. This is a reasonable payoff:risk ratio. In the three week perspective, there is a chance of getting some returns on both an upswing as well as downswing.

STOCK FUTURES/OPTIONS

Friday's recovery was triggered by the derivatives market "� traders cashed profits in stock futures that drove futures prices up and induced spot prices to rise as well. Scrips outside the F&O segment did considerably worse than the larger caps. Traders would therefore be sensible in sticking inside the purview of the most liquid scrips.

The ADAG scrips like Reliance Capital, RNRL and RCom generated massive volumes and big jumps on Friday, as did Reliance Infra. Shree Renuka has also generated unusual volumes. But the most interesting counter seemed to be DLF where a downtrend reversed very sharply. Keep a stop at 400 and go long.