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Tuesday, Jan 21, 2003

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Buy January calls on Tata Steel

B. Venkatesh

THE following strategies are based on Monday's trading in the derivatives segment on the NSE. The immediate outlook on Satyam Computer and Tata Steel appears negative, but both stocks may bounce back from such price dips.

The strategies mentioned below are structured to payoff in the event of price reversals after the stock goes down. The positions are highly risky.

Tata Steel: The upside price target is Rs 164. The risk is that the stock may fall to Rs 144, its first support level. Note that the upside price target and the downside risk level are near symmetrical from the current spot price.

Consider buying the January 155 calls, as they are cheaper in terms of implied volatility. The calls are trading rich, and therefore, do not provide any margin of error for forecasting volatility.

The directional risk is high, as the calls are in-the-money (ITM). The benefit from long gamma is small, while the loss in option value due to passage of time is moderate. The net effect is that the theta-gamma trade-off is moderately high. The implication is that the calls will not rapidly lose value, even if the stock's upside drift is slow. The vega risk is very small, which suggests that the calls will not rapidly lose if volatility falls, the likelihood of which is higher.

If the stock rises to Rs 164, the January 155 calls will generate 145 per cent returns. The calls will tend towards zero, if the stock declines to Rs 144.

The target trading-horizon for this position is 5 days. The market lot is 1,800 options per contract.

Satyam: The upside price target is Rs 272. The risk is that the current bout of profit-taking could push the stock down to Rs 250, its first support level.

Consider buying the January 270 calls. Your payoffs will be attractive only if the calls are bought at stock dips, and not at the current levels. If the stock declines from Rs 259.20 to just Rs 255, the theoretical value of the 270 calls will fall by 40 per cent. The risk is that the calls will fall sharply if the stock falls further. This suggests that the option delta is not a good approximation of the calls' downside risk.

If the stock climbs to Rs 272, the January 270 calls will generate 30 per cent returns. The calls will tend towards zero if the stock declines to Rs 250.

The target trading-horizon coincides with the expiration of the January contract. The market lot is 1,200 options per contract.

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