Markets

How to capture a likely limited upside for Nifty in May F&O series

The stock market is at a make or break level after crossing an important hurdle at around 10,708.55 — the so-called 61.8 per cent Fibonacci retracement from its 9,958.55 low of March 26 — on Friday, managing to close at 10,739. Those with a penchant for risk have initiated a call ladder spread, an options strategy on the Nifty that aims at capturing limited, 2.4 per cent, return through 11,000 this month.

The call ladder involves purchase of a 10,700 call option (at-the-money), and sale of a 10,900 and 11,000 call (out-of-the-money options). All options expire on May 31. Near month Nifty options show that the index faces resistance at 11,000 and gets support at 10,500. At the current level, the Nifty is 2.4 per cent away from 11,000.

While the sale of an extra call at a higher strike (11,000) reduces the debit of the strategy significantly, it increases the element of risk substantially if the Nifty breaks past 11,000. Thus the strategy is risky and brokers recommend it mostly to HNI and ultra-HNI clients.

Heres how it works: At Monday close, the 10,700 call costs the trader Rs 188 a share (75 shares equal one contract). The 10,900 call fetches her Rs 79 and the 11,000 call another Rs 43, or a combined Rs 122 a share. The sale of the two calls effectively cut the cost of the 10,700 call to Rs 66 a share. The maximum profit that a trader makes in the strategy is Rs 134.

So long as the Nifty expires at 11,000 this series thats the maximum the trader rakes in (Rs 134 a share). Thats a risk reward of 2:1. The loss in case the Nifty closes at 10,700 or below is the debit of Rs 66. However, were the Nifty to close above 11,134, the trader would face unlimited losses unless she places a stop loss.

At 11,000, the 10,700 call is Rs 300 in the money and the 10,900 call becomes Rs 100 in the money. After paying off the 10,900 buyer, the trader is left with Rs 200. Since she expended Rs 66 to initiate the strategy, the return less taxes and brokerage is Rs 134.

However, every point that the Nifty rallies above 11,000, reduces the traders profit until the index touches 11,134, the breakeven after which she begins losing money. Assume the Nifty closes at 11,150. The 10,700 call is worth Rs 384 (minus the Rs 66 debit). However, the sold 10,900 call and the 11,000 call are worth Rs 250 and Rs 150 a share, respectively, or a combined Rs 400. That leaves the trader with a loss of Rs 16 (minus brokerage, taxes, etc) a share.

Chandan Taparia, derivatives analyst at Motilal Oswal Securities, however, feels the Nifty is unlikely to cross 11,000 in a hurry and head for its record high of 11,171.55 hit on January 29. He has advised his clients to do this trade to “capture” the “limited” upside at “cheap” cost, thanks to the call ladder.

Rohit Srivastava, fund manager — PMS — Sharekhan by BNP Paribas, agrees on the “expediency” of the strategy but warns that any increase in the benchmark bond yield above 7.8 per cent (10 Year govt bond at 7.6 per cent on Friday) could queer the pitch and pose a risk to equities. Also, a rise in the benchmark US bond yield above 3 per cent could push FPIs to selling emerging market shares as the cost of funds begins to take the sheen off carry trades.

Original Article

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