Keynote derivatives daily report for 280313

Daily Derivatives Outlook

28 March 2013

Indices Positional Option Trades
Nifty Short Strangles
Highest Call OI at 5700 SELL Nifty April 5900 CALL and 5400 PUT
Highest Put OI at 5600
Short Straddle at 5650 at combined premium of 42 SL 65

MARCH 5700 & 5600
Bullish Stock Option Trades

APRIL 6000 & 5300, 5900 & 5400
5800 & 5500 Buy Hind Unilever 480 CALL at 1.45

Buy Ranbaxy 440 CALL at 7.3
MAY 6100 & 5200, 6000 & 5300
5900 & 5400, 5800 & 5500 Buy ITC 300 CALL at 6.3

Buy HDFC 820 CALL at 8.45
Bank Nifty Short Strangles
Highest Call OI at 11500 Buy Titan 250 CALL at 3.5
Short Straddle at 11200

MARCH
Bearish Stock Option Trades
11400 & 10800

11300 & 10900 Buy Reliance 780 PUT at 3.8
USD/INR
Highest Call OI at 54 Buy Tata Steel 300 PUT at 1.2
Short Straddle at 54.75 Buy Reliance Power 60 PUT at 1.15

Buy DLF 230 PUT at 1.15
APRIL 56.5 & 53
Buy Hero Motors 1550 PUT at 7
56 & 53.5

55.5 & 54

Keynote Capitals Ltd.
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The Ruby, 9 Floor, Senapati Bapat Marg, Dadar (W), Mumbai, India – 400028. Tel: 3026 6000 / 2269 4322

READY RECKONER ON OPTION AND TECHNICAL STRATEGIES :

INTRODUCTION TO OPTIONS:

 Options are Wasting Assets with Option Pricing like Insurance Pricing.

 Strike Price is similar to Age of the Assets.

 OTM(Out of the Money) are Low Probability strikes (young assets), ATM (At the Money)
are equal probability strikes (average age assets) and ITM (In the Money) are High
Probability strikes ( old assets).

 Premium reduces from ITM to ATM to OTM as probability of event happening reduces.

 Mirror Image Concept : OTM for Calls is same as ITM for Puts and ITM for Calls is same as
OTM for Puts.

 View for Strike Selection : OTM - Strong conviction. ATM - Moderate conviction . ITM –
Low Conviction

 Advantages of Options – Profit from Trading range Markets, High Leverage, Built-in Stop
Loss, Higher Probability of Profit using Spread Trades, Increase in trading opportunities due to
multiple legs, Lower Margin requirements due to high gearing in options, Increase in Reward to
Risk ratio.

OPTION INTERNALS:

 Call-Put Parity : Futures Price = Strike Price + Call Premium – Put Premium

 Put Call Ratio ( Open Interest) is bullish at levels between 0.8 to 1.2 and bearish between
1.75 to 2.

 Equilibrium strike is with equal Call and Put Open interest with Highest Call Open interest
strike as resistance and Highest Put Open interest as support.

 Greeks – Delta is the Probability. Gamma is the Change in Delta. Theta is the change in time
remaining.

 Vega is the Change in Volatility (VIX) and Rho is the Change in Interest Rate.

 If VIX ( Volatility Index) is above average selling options is preferred and if VIX is below
average buying options is preferred. The long-term average of the India VIX is around 24.

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 Historical Volatility (Realized Volatility) is based on the standard deviation of the underlying
asset while Implied Volatility is derived from the option premium traders are willing to pay to
hedge their positions.

 The Put Implied Volatility generally trades at a premium to Call Implied Volatility with panic
or fear conditions in the market leading to expansion of the premium.

RISK MANAGEMENT:

 Risk Management using options - Quantify the maximum risk and maximum reward and the
breakeven points of a position before committing capital. A risk manager always focuses on
how much can be lost in a position. Control the losses and the profits will take care of
themselves. Determine an exit strategy in advance for every trade initiated. An exit strategy
enables closure of loss-making positions unemotionally so that there is no freeze or panic
when confronted with the loss.

 Stop Loss : Use 50% stop loss for premium paid or received for both one-leg and multiple-leg
strategies.

ONE-LEG STRATEGIES:

 Long Call and Long Put are Limited Risk and Unlimited Reward strategies.

 Short Call and Short Put are Unlimited Risk and Limited Reward strategies.

TWO LEG STRATEGIES:

 Long Synthetic ( Buy ATM Call and Sell ATM Put) and Long Combo( Buy OTM Call and Sell
OTM Put) are used to create synthetic long positions which have lower margins than
comparable futures positions.

 Short Synthetic ( Buy ATM Put and Sell ATM Call) and Short Combo( Buy OTM Put and
Sell OTM Call) are used to create synthetic short positions which have lower margins than
comparable futures positions.

 Long Straddle, Long Strangle and Long Guts are Long volatility strategies ahead of
events/results etc.

 Short Straddle, Short Strangle and Short Guts are Short volatility strategies when range-
bound action is anticipated.

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TWO-LEG FUTURE AND OPTION COMBINATION STRATEGIES:

 Protective Put and Protective Call protect futures positions by buying options.

 Covered Call/Ratio Call Write and Covered Put/Ratio Put Write cover futures positions by
selling options. They involve unlimited risk and limited reward.

 Collar is a combination of the Covered Call and the Protective Put or the Covered Put and
the Protective Call.

TWO-LEG AND THREE- LEG SPREAD STRATEGIES:

 Bull Call Spread, Ratio Bull Call Spread and Bull Call Ladder are bullish debit spreads
which involve buying a lower call option and selling upper call options.

 Bear Put Spread, Ratio Bear Spread and Bear Ladder are bearish debit spreads which
involve buying a upper Put option and selling a lower Put option.

 Bull Put Spread is a bullish credit spread which involves selling a upper put option and
buying a lower put option.

 Bear Call Spread is a bearish credit spread which involves selling a lower call option and
buying a upper call option.

 Call Ratio Backspread is a credit spread which involves selling one or two lower strike calls
(ITM or ATM) and buying two or three upper strike calls.(OTM).

 Put Ratio Backspread is a credit spread which involves selling one or two upper strike puts
(ITM or ATM) and buying two or three lower strike puts.(OTM).

FOUR-LEG BUTTERFLY AND CONDOR STRATEGIES:

 Long Iron Butterfly is a credit strategy using a combination of the Short Straddle and
Long Strangle, while in a Long Iron Condor the middle strikes are separated.

 Short Iron Butterfly is a debit strategy using a combination of the Long Straddle and Short
Strangle, while in a Short Iron Condor the middle strikes are separated.

 Long Call Butterfly involves buying a lower strike call (ITM), selling two middle strike calls
(ATM) and buying a upper strike call(OTM). In Long Call Condor the middle strikes are
separated.

 Long Put Butterfly involves buying a lower strike put (OTM), selling two middle strike
puts(ATM) and buying a higher strike put (ITM). In Long Put Condor the middle strikes are
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separated.

LONG TERM OPTIONS and CALENDAR/DIAGONAL STRATEGIES

 Long Term Options can be used to create investment grade positions using spreads,
synthetics and covered /protective positions.

 Calendar/Diagonal Calls is a debit spread involving buying a long-dated call option and selling
a short-dated call option against it ( Diagonal Calls involve different strikes).

 Calendar/Diagonal Puts is a debit spread involves buying a long-dated put option and selling
a short-dated put option against it ( Diagonal Puts involve different strikes).

DELTA HEDGING METHODS

 The distance between the current market price and the short option breakeven point is
divided into equal parts so that futures exposure is increased at consecutive delta
adjustment points to ensure that the short option position is totally hedged by the time the
breakeven point is reached.

 The size of the short option position is directly proportional to the distance of the short
breakeven point to the current market price. Position size should be maximum at deep-out-of-
the money strikes and reduce gradually as the distance to the market price reduces.

 Short gamma positions carry the maximum risk and using options instead of futures to hedge
is advisable since futures does not cover the gap risk, while using ITM options covers the gap
risk

USING OPTIONS WITH SUPPORT/RESISTANCE AND MOVING AVERAGES:

 Buy call options at Support ( Bottom-fishing) and above resistance ( Breakout) .

 Buy Put options at Resistance ( Top-picking) and Below Support ( Breakdown).

 Moving Average Crossovers – Buy call options if price crosses the moving average from
below and buy put options if price crosses moving average from above.

 The one month options can be linked to the 20dma with the three month options linked to
the 50dma and the 1 year options linked to the 200dma.

USING OPTIONS WITH OSCILLATORS:

 RSI – Buy call options when RSI is below 30 and Buy put options when RSI is above 70.
The RSI 50 crossover can be used to buy calls on the upside crossover and to buy puts on
the downside crossover.

 MACD and Parabolic SAR early warning buy signals indicate buying of calls ( bottom-

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fishing) and sell signals indicate buying of puts ( top-picking).

 ADX indicates the strength of the trend and whether the market is in a trending or trading
mode. When ADX is above 25 and +DI is above –DI then buy calls and if –DI is above +DI
then buy puts. When ADX is below 25, then selling strangles and straddles will be profitable.

 Widening Bollinger Bands indicate increasing volatility and option buying is advised as
a trending move is expected.

 Flat or Narrowing Bollinger Bands indicate reducing volatility and range-bound option
selling strategies are advised.

MARKET INTERNALS:

 Market Breadth Indicators – Volume and Delivery Volume Expansion, Open Interest
Expansion and Contraction, Advance/Decline Ratio, 52 Week Highs/Lows.

 Open Interest Expansion and Contraction Rules –

1. Price Up and Open Interest Up – Long Buildup

2. Price Up and Open Interest Down – Profit Taking

3. Price Down and Open Interest Up – Short Buildup

4. Price Down and Open Interest Down – Short Covering.

SECTOR AND STOCK SELECTION:

 Defensive stocks have low to moderate beta in sectors like FMCG, Healthcare, IT, Cement,
Telecom.

 Cyclical stocks have high beta like Financials and Rate Sensitives like Auto, Infrastructure,
Realty.

 Stock Selection – Invest in the constituents from broadbased indices like Nifty, Junior Nifty
and Midcap as well as constituents of Sectoral Indices like Auto, Banking, Capital Goods, IT,
FMCG, HC etc.

 Alpha Strategies - Long Stock and Short Index( Outperformance) or Short Stock and Long
Index ( Underperformance).

 Pair Strategies - Long Stock and Short Stock within the same sector.

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