Capitalise on range-bound Nifty with long volatility, bear-spread trades

The Nifty had a volatile range-bound trading last week between 5750 and 5950, with the benchmark index closing the week with a small loss of 18 points.

The Nifty futures premium to the spot index closed almost at parity on Friday after trading at a high of 35 points on Wednesday. The short covering in the Nifty futures on Wednesday led to an expansion of the premium.

However, disappointing earnings guidance from IT major Infosys led to contraction of the Nifty futures premium to parity as the shorts were reinstated.

The India VIX Volatility index closed at 21.6 on Friday, gaining 5% for the week. The India VIX has made a strong base around the 20 levels for the last four weeks and a crossover above short-term resistance at the 23 levels could lead to further weakness in the Nifty.

The premium of the put implied volatility to the call implied volatility for Nifty options has started moving up after falling to parity levels earlier this month. This revival of interest in put buying after a period of complacency on the part of the market participants is a sign of caution at current levels.

The Nifty options chain analysis shows that call writing has taken place in strikes 5800 to 6000 on Friday with the highest call open interest at the 6000 call. Put unwinding has happened on Friday at 5700 to 6000 strikes with the highest open interest at 5700 put.

The Nifty equilibrium, which has put-call ratio nearest to 1, is at the 5800 strike. The Nifty equilibrium has been oscillating between 5800 and 5900 last week due to extreme volatility between 5750 and 5950, which has caught the option writers on the wrong foot.

The IT sector saw aggressive short build-up led by Infosys and to a lesser extent in Wipro and HCL Technologies.
The real estate sector had short increments in DLF and Unitech while Indiabulls Real Estate was the contrarian long with smart open interest additions. Mid-cap private sector banks Yes Bank and IndusInd Bank had moderate long build-ups.

The oil and gas sector had mixed cues with Petronet LNG on the long side and Reliance Industries on the short side. Hero Honda and ITC were the other counters with long additions.

To capitalise on the range-bound trading in the Nifty and with volatility being at the lower end of the range, spread trades or long volatility trades are recommended.

Since the Nifty is at the upper end of the four-week range of 5400 to 5950, a bear spread trade can be initiated by buying at-the-money put at the resistance strike and selling out-of-the-money put at the support strike.

Alternatively, a long volatility trade by simultaneously buying a call and a put of the resistance strike (long straddle) is suggested.

The spread trades are advantageous due to time decay of options being neutralised by the sold option. The long volatility trades have a market-neutral view and they also benefit if there is a volatility spike.

The writer is associate vice-president -technical equities with Motilal Oswal Securities Ltd