Monday, April 6, 2009

Nifty Strategy for the week 6 April 09

Wide long strangles may be profitable
Devangshu Datta / New Delhi April 6, 2009, 0:55 IST

Though spot market shows signs of overheating, markets can trend up for long periods while appearing overbought.

Sentiment has been cheery through the opening week of the April settlement. Trading volumes have been high and prices have risen with high velocity.

The FIIs made a significant contribution to the rally. They were net buyers through March and hold around 38 per cent of open interest. Local traders have also returned to the bourses. In the first few sessions of April, daily derivatives volumes comfortably crossed Rs 50,000 crore. During the past six sessions, the FIIs have been net sellers thrice. The implication is that local traders are major participants in the bull run.

The Nifty has risen nearly 20 per cent in the past three weeks. If the run up continues past stiff resistance at just above current levels, the Nifty could achieve targets of around 3,450. Under normal circumstances, one would see this as cause for optimism.

However, in the context of impending elections, it looks like a big bull-trap. Statistically, elections are strongly correlated with high volatility and bearishness. The election period always sees expansion in the daily trading range and prices tend to crack during that period of a month to six weeks. This is regardless of sentiment before or after elections.

The only election that broke this pattern of bearishness was 1999 when post-Kargil euphoria and the hope that a lame-duck government would be replaced by a stable coalition drove the market up. Such circumstances hardly apply now. In 2004, a bull market was interrupted by a 20 per cent downswing that was only halted when the UPA government promised some stability.

If this election holds true to pattern, April and May should see prices swings of over 20 per cent – approximately a range of 1,000 points. If we posit a price range of 2,500-3,500, that roughly holds. It would also hold if the market moved from 3,000 to 4,000 as the optimists expect. It would also hold if the market slid from 3,200 to 2,200.

There are some clear price levels in terms of congestion. There’s strong support at 2,850-2,950 and below that, there’s strong support between 2,500-2,600. Below that, it would be 2,250. On the upside, there’s resistance between 3,200-3,280. if the market clears that, there’s a run till 3,450 level. Above that, there’s huge resistance.

It’s tough to call next week in terms of direction. The spot market shows some signs of overheating but markets can trend up for long periods while appearing to be overbought. The Nifty futures and CNXIT futures are both at some premium to their respective underlyings. This is usually a bullish signal especially in circumstances where open interest has risen.

The Nifty put-call ratio is reasonably healthy but it’s edging up to dangerous levels. In terms of open interest, the overall Nifty PCR is at 1.7 while the April PCR is 2.1 with around 67 per cent of OI in the April PCR. PCRs above 2 are unusual – this has been caused by a cashout of calls while outs have increased. It could signal a dramatic shift in the trend – either an acceleration to the 3,450 level or a drop.

The Bank Nifty has been a key driver for the overall market. It saw some profit-taking last Friday and for a change, it underperformed the Nifty. If this is a leading signal, rather than a temporary aberration, it could mean a profit-taking spree.

There are several ways to try and cater for big swings. The simplest is wide long strangles. A long 3,400c (44) and a long 3,000p (47) for instance, costs 91 and can be laid off with a short 2,800p (20) and a short 3,600c (12). That reduces the net cost to 59 and offers a maximum return of 141 if either position is hit and realised to the limit.

An even wider strangle of long 2,800p and long 3,600c would cost just 32 and breakeven at 2,768 and 3,632. This position depends on high delta since it’s less likely to be struck. If the premia changes rapidly with respect to change in the underlying’s price, the position could be profitable. A fan of Nassim Taleb would probably go with a naked, long 2,700p (14.5) hoping for a massive return if the position is struck.

It may be worth taking standard bullspreads and bearspreads with greater width than normal, relying on higher volatility. For example, a long 3,300c (79) and short 3,400c (44) is a near-the-money position that offers a maximum return of 35.

A long 3,400c (44) and short 3,500c (24) offers a maximum return of 80 for a cost of 20. Similarly a long 3,200p (107) and a short 3,100p (72) costs 35 and pays a maximum of 65. A long 3,100p and short 3,000p (47) costs 25 and pays a maximum of 75. Anyhow, the near-the-money offer decent return-risk ratios.