Using bull spreads to ride the upmove makes sense

The Nifty continued the rally last week after stellar gains from a week before. Last week saw the expiry of all March series futures and options contracts.

The reason for its importance is that this gives an idea about the extent to which the participants are willing to take their trading bets forward, indicating the consensus on the trend.

March series saw stock rollovers of 85% (six months average is 83%) and Nifty rollovers of 67% (six months average is 65%).
Stock futures had seen slow and steady incremental participation even through the consolidation period of the index last month.

However, the aggregate open interest never crossed 2 billion shares even towards the end of the expiry.

Hence, despite slightly above-average rollovers, stock futures saw a decline in total open interest expiry over expiry.

Nifty futures, on the other hand, attracted a lot of open interest towards the end of the series, which, alongside the above-average rollovers, has led to rise of over 10% in open interest expiry over expiry.

Nifty futures rolled at premium of over 50 basis points (bps) towards the end of the expiry, indicating trading longs were rolled into the next series. Among specific sectors, banking, IT and shipping & transportation stocks rolled faster than the six-month average, while engineering & realty shares rolled slower.

On the aggregate basis sugar, infrastructure and chemical & fertiliser stocks saw impressive rollovers.

The key observations from the rollovers are:
1) The focus may move to non-index stocks as indicated by long rollovers and expiry-over-expiry increment in open interest.
2) Sector-wise rollovers indicate longs in cement and infra stocks being rolled in to next expiry in anticipation of further gains.
Nifty options started to trade at very low implied volatilities (IVs) after the event of expiry was over. This indicates expectation of stability in the market.

Empirically, whenever IVs drop significantly, the underlying tends to move upward. The same thing happened to Nifty as well as it shot up towards the end of the month post the drop of IVs by around 5% from the top.

As far as view going forward is concerned, Nifty April options are composed with a moderately Bullish open interest put-call ratio of 1.13. Interestingly call strikes just above the current Nifty level have higher open interest. This generally happens after a big move up, as the participants try to cash in on the slowdown in a rise.

We feel one may play the further upmove through bull spreads, where one buys a call of the strike nearest to the current price and simultaneously go short on the call option on the same underlying with the strike which is nearest to the intended trading target.

This lets one play with known loss strategy and reduces the loss of premium due to time. While the long futures players can be long on put and simultaneously be short on call of the strike that is near the trading target. The strategy essentially reduces the risk element of the trade.

The writer is manager-derivatives at Motilal Oswal Securities Ltd