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Market may head into a small correction

October 01, 2007 12:47 IST

The bear spread offers the best risk:reward ratio and makes sense even if the market could continue to go up.

A strong trend in the spot market translated into settlement with good carryover and very high volumes in the futures and options market. In particular the FIIs have big exposures across both markets.

There is already excellent open interest in the October stock futures segment and also in the Nifty options segment. Thus, there is a very good chance that October will see most of the current futures and options volume records being broken.

Index strategies

There is a small premium in the Nifty futures market versus spot. On Friday the spot Nifty closed at 5021 while the October Nifty was last traded at 5037.

The November Nifty was held at 5026. In the spot market, the Junior closed at 9821 while the October Junior contract was last traded at 9808.

The Bank Nifty closed at 8042 in spot and at 8114.7 in the October futures. The CNX IT closed at 4804 in spot and at about the same level in the futures. Apart from the Nifty, there isn't much open interest in the November series.

A premium in the Nifty futures is unusual at this early stage in a settlement and it's a bullish signal. However, this differential is tough to exploit directly. You would have to buy a basket of Nifty heavyweight shares and simultaneously sell the future.

The difference between the Nifty October-November futures is of normal dimensions and likely to remain at those levels. This is a comparatively short settlement so arbitrage opportunities could come up by the third week of October.

In technical terms, the banking sector looks very bullish and that makes the massive premium of the Bank Nifty future unfortunately difficult to exploit.

The CNX IT is less bullish despite last week's jump. It's quite likely to see another decline if there's either further rupee strengthening or disappointing Q2 sector guidance.

That is extremely likely so there is a case for going short on the CNX IT and holding the position until Infosys and TCS have declared Q2 and (probably) revised their full year guidance downwards.

The Nifty Junior could actually move up more than the Nifty itself because it has a higher concentration of bullish financial sector counters. Given the mild discount on the Junior future, you could go long here.

In the options market, it's difficult to set technical parameters for the likely range of the next week. On the downside, there is support at 4950 and lower down as well. For practical purposes, it would be okay to assume that the Nifty is unlikely to drop below 4850 in the next week.

However on the upside, we are in completely new territory. One can project a possible target of 5200 but this is really imprecise given the lack of previous history. For what it's worth, there is liquidity in the chain until the 5250 level so we may as well take that as the likely upper limit.

One disquieting signal is the drop in the put-call ratio. Taken in terms of open interest, this hovered above 1.5 throughout most of the September settlement. It has dropped to 1.19 at the moment. While that is bullish in principle, it is a significant fall and could indicate a likely short-term correction. As mentioned above, the first support is at 4950.

A bull spread with long 5050c (131) versus short 5150c (84) costs about 47 and pays a maximum of 53. A bear spread with long 5000p (125) versus short 4900p (90.5) costs about 34.5 and pays a maximum of 66.5.

Obviously the bear spread offers the best risk:reward ratio and the two positions are approximately equal distances from the money.

This may be one of those situations when it makes sense to go with the bear spread even though the market seems more likely to move up than down. If you want a bull spread get further from the money and go with a long 5100c (101) and short 5250 (43) combination that offers a maximum return of 92 for a cost of 58.

Straddles in the current situation only makes sense if they are quite far from the money because premiums are high and it's a trending market. A long 4850p (75) and a long 5200c (61) combination costs about 136. That would mean breakeven comes only outside the 4715-5336 range. This would require either an unbridled bull run (possible) or a massive crash (less likely) through the next three-four weeks. Better to avoid this.

Stock Futures/Options

There could be rich pickings across the stock futures sector given the number of counters heading for new all time highs.
However, the most interesting arbitrage possibility arises in Reliance Industries, which is finally seeing a bit of profit-booking. The stock closed at 2298 while the future was last traded at 2317. That leaves some room for selling the future and buying the underlying.

Apart from this, there has been another spike in interest in Nagarjuna Fertilisers, which has led to an F&O ban unusually early in the settlement. The bull run could continue here.

In RNRL, operators have developed sufficient confidence to generate serious call option volumes – most unusual in a relatively less liquid counter.

This is also true for IFCI where there is major open interest even in the 115c (5). You could create a bull spread with long 100c (10.7) and short 115c. The maximum payoff would be 9 on an outlay of 5.7. The rest of the interest seems to centre on the usual suspects – Tisco and Sail could prove to be a useful long pair and practically every bank in sight has developed strong open interest.

Devangshu Datta in New Delhi
Source: source