A Big Breakout On the Cards?

Monday, May 19, 2008 | | |

Both bear and bull spreads offer decent returns.

It was a low volatility week when trading patterns ran contrary to macro-economic trends. Although inflation continued to soar, stock prices also rose and the action in the derivatives market reflected some of the (possibly misplaced) optimism.

Index strategies
Volumes remained average in the F&O market but there was healthy carryover and OI build up. There was some evidence that Indian operators were in the market, given that the level of FII exposure stayed at around 40 per cent of total outstandings.

Range-bound markets have certain characteristics. Typically, cash volumes are low, daily volatility drops and this is reflected in lower implied volatility in derivatives. The lower IV in turn creates a trap because a breakout changes all the variables. As volatility jumps, the unwary get clobbered.

The VIX suggests that aggregate market expectation is that range-trading will continue. At Nifty 5300-levels two weeks ago, the VIX was trading at about 21 – an all-time low. At the current Nifty 5150-odd, it is 23, which one would still consider overbought. A low VIX implies that the market does not expect a breakout, at least on the downside.

This could be very dangerous. There's still two weeks for settlement and expectations of continued range-trading are reflected in option chains and high carryover volumes.

In the option chain, there is zero liquidity above 5500 and calls are being extinguished above 5400. On the downside, puts have been extinguished at a loss in the 4700-4900 range.

This is unusual and even irrational. The Nifty frequently swings 2.5-3 per cent per session if you look at average long-term volatility. That's 150-175 points – and losses are being booked in positions 250 points from money with 10 sessions to go.

Overall OI has risen and it's heavily concentrated in the 5000-5300 range. What is more, approximately 32 per cent of all option OI is in the June-July series. This is high carryover – two weeks from settlement, the mid+far contracts would normally generate about 15 per cent OI. The mid+far OI is also concentrated in the 4900-5400 range, implying few bets on a breakout.

Usually the market breaks out of range-trading within 3-4 weeks or so, and daily volatility is guaranteed to rise when it does. As and when there is a breakout, a lot of traders are going to play a frantic game of catch-up. It will be especially entertaining if this happens in settlement week.

In such a situation, the option trader can adopt two strategies. One is to go with the herd and add an element of safety through covered spreads close to money. As it happens, both bullspreads and bearspreads CTM are offering reasonable return:risk ratios.

The other possibility is more daring. The trader can look for wide straddles and strangles that don't cost much and offer big gains in case of a breakout. Here the lack of liquidity and the expiry factor makes that more expensive. It isn't possible to build short strangles very far from money. But the positions are still worth considering.

Of course, the vast majority of traders are actually in naked index futures rather than options. The technical situation in the index futures market is difficult to read. Only the Nifty and MiniNifty have decent liquidity in the mid and far contracts. There are no calendar arbitrages available and there is a reasonable carryover trend. The low VIX makes me inclined to suggest short positions.

In the other indices, the Junior's May futures was settled at 9046.5 while the spot closed at 9014.9. The BankNifty was settled at 7606.7while the spot closed at 7644.6. The CNXIT was settled at 4543.5 while the spot closed at 4552.65. The Midcap-50 was settled at 2754.65 while the spot closed at 2746.85.

The BankNifty has seen short-covering late on Friday and if this pattern continues, it's worth being long. The CNXIT has responded positively to a weak rupee. A rupee rise is now on the cards because the RBI may intervene to reduce the impact of high crude prices. So a short CNXIT seems slightly more likely to work.

In the Nifty options market, a long 5200c (60) versus short 5300c (26.95) costs 33 and offers a maximum return of 67. A bearspread with long 5100p (63.35) versus short 5000c (38.15) costs about 25 and offers a maximum return of 75. Both are very decent risk:return ratios.

A long strangle of long 5300c and long 5000p costs 65. This can be laid off with a short 4800p (14) and a short 5500c (6.35). That reduces the cost to 44 and the potential return on either breakout is 156. That's a pretty good return:risk ratio though there is an expiry risk. The position would be fully realised if the market moves 350 points in either direction. That requires two big trending sessions within the next 10.


There are several stocks that are generating high futures volumes and therefore worth a careful look. Cairn is one of these, SAIL is another and a third is HDIL.

SAIL is also generating a lot of volume in the 180c and that is very unusual. RCom (about 602 in both futures and spot) is also generating high futures volume which is usual. It is also generating high volume in 600c (14.8).

SAIL is at about 186 in both cash and futures and the 180c last traded at 10 while the 190c was at 5. A long SAIL futures will probably generate more profit than a long call but a bullspread is also possible. It's in the money at current prices (which means that both 180c and 190c will rise).