All roads lead south

The focus range for an options trader would be between 4000-4600.

The bearish momentum of the past two months translated into a settlement characterised by very high volumes and high volatility. There was good carryover but the bearish sentiments have obviously persisted. The current signals across cash and derivatives markets suggest that another fall is imminent.

Index strategies The FIIs sold over Rs 10,000 crore in June and they are likely to continue operating in the same fashion in early July at least.

Despite the P-Note overhang, their collective derivative exposure has increased to around 44 per cent of all outstandings. This is of course more than balanced by the large-scale exits in the spot market.

The key figure for FII attitude-watchers is index options - these are currently around 29-30 per cent of total FII OI. That is in the normal range. Sometimes a shift in FII attitudes translates into a spike in index option holdings, presumably due to hedging. Since this hasn't happened, they are likely to continue selling.

In the index futures market, although the carryover was satisfactory and supplemented by high-volumes on Friday, all index futures are trading at very substantial discounts to spot levels.

The Nifty July, August and September contracts were settled at 4075, 4068 and 4067 respectively while the spot index closed at 4136 on Friday. These are historically massive differentials in terms of near-contract to spot.

The situation is similar in the BankNifty, the CNXIT and the Midcaps-50 though only the BankNifty has serious liquidity at this instant. The BankNifty incidentally broke a key support last week and it could continue down.

This is not surprising given the prospect of major monetary tightening through the next few months. A trader could go short in the BankNifty with a certain degree of comfort. Since major banks such as SBI and ICICI have significant weight in the Nifty, this is also a point to be borne in mind as well when considering Nifty direction.

Apart from the bearish implications of massive discounts to spot, there are arbitrage opportunities here. Arbitrageurs will try to sell spot and buy futures to collect on the difference and that will have a directly bearish effect on spot prices.

The VIX has been signalling extreme disquiet, hitting intra-day of over 50 and closing at near-record levels of 32+. Again this is a bearish signal that has tended to be quite accurate in the admittedly short history of this indicator.

Another bearish signal has been emitted by the Nifty put-call ratios. In absolute terms, the ratios on Friday were below 1 - this is bearish. The July PCR is also below 1 in terms of OI although the far and mid contracts have been closer to normal at 1.4 or so.

PCR tends to offer fairly reliable signals. A low PCR usually means bearishness though there are extreme levels of lows and highs that signal trend reversal. We haven't reached those extreme values yet.

All this bearishness shows in the liquidity in the lower reaches of the options put chain. Over 45 per cent of all Nifty put OI is nested in the 4000p and the 4100p contracts. That means that around 50 per cent of traders holding in-the-money puts have not yet cashed in. The 4000p is priced at 150-plus, which is amazing given that it's quite far from money. Sadly there is no liquidity below 3950.

Technical target projections from the spot market indicate this move will run down till 4000. So that is a key support level reinforced by the put OI. If 4000 is broken, the market could go into free fall simply because nobody is expecting it. This could happen if the nuclear deal finally short-circuits the UPA.

In analogy, the call option chain has just 7.5 per cent OI in the money (4100c or below) and 75 per cent of OI is clustered between 4200 and 4600 contracts. We could see 4600 as the upper limit in case of a recovery. Our technical projections actually suggest that resistance between 4400-4500 is likely to be insurmountable.

Hence the focus range for an options trader would be between 4000-4600. A bullspread with long 4200c (130.05) and short 4300c (91.8) offers a maximum payoff of 62 against an initial cost of 38.

A bearspread with long 4100p (197.05) versus short 4000p (152.85) offers a maximum return of 55 for a cost of 45. Obviously the bullspreads have better risk:reward ratios but that is normal in a bearish market.

My take is that, given that the 4200-4300 bullspread is close to money and early in a long settlement (July 31), a bullspread can be risked. Sometime in the next week or so, there is likely to be a big up-session when the long put-holders finally decide to book profits.

Strangles such as long 4000p and long 4300c cost too much and cannot be laid off due to lack of liquidity below 4000. Hence, it's difficult to cater to breakouts.

STOCK FUTURES/ OPTIONS There are some arbitrage opportunities in stock futures because many futures are trading at discounts to underlying security. The theory would be sell underlying scrip and take a long future. In practice, this can only be done against delivery. The stock futures trader will have to focus on a narrow range of high-volume contracts. Most of the tempting positions are shorts. A long futures player would have to pick underlyings that show potential to bounce sharply in a technical recovery and even then, he would be going against the trend. Reliance Industries and Cairn are two long positions that fit criteria in terms of liquidity and technical outlook (Source: B.S.)