Introduction
With the Nifty50 and the Sensex at all-time highs, and the Nifty VIX near all-time lows, traders may start to experience analysis paralysis: Should you go long and continue to ride the market to even higher highs, or bet on a short-term market pullback? This article will show you how to take advantage of this current environment as an options trader.
What is the VIX?
VIX = volatility index. In short, it is the market’s projected volatility for the next month and is based on the options market for the Nifty 50. The current value is 13.53%. What this means is that based on the Nifty 50 options trading, the Nifty 50 is expected to move approximately +/-13.53% over the next year.
The Nifty VIX value (or volatility) is often inversely related to the Nifty50 performance. When the Nifty50 falls dramatically, volatility increases. When the Nifty50 has record positive performance, volatility decreases.
An interesting phenomenon is that when the VIX is at highs and lows, there tends to be lower option trading volume. This is in line with our analysis paralysis comment.
In fact, traders who only focus on bullish or bearish outcomes are limiting themselves to profiting solely from directional options trading strategies.
Directional options trading strategies are exactly what they sound like – strategies that win based on the trader being correct on the direction of the underlying index’s (or stock’s) movement.
For example, if the trader believes that the underlying will move up, the preferred option trading strategies could be a long call option or long bull call spread. On the other hand, if the trader believes that the underlying will move down, the preferred option trading strategies could be a long put option or long bear put spread.
An alternative to directional options trading strategies are ‘non-directional options trading strategies’. These strategies win whether the underlying moves or does not move; the specific direction doesn’t matter.
Our Point of View: When the VIX is at a high or low, there are unique option trading opportunities that emerge in the form of non-directional trading strategies. In addition, there are additional opportunities to purchase low-cost equity hedging which could reduce your downside risk should a stock that you own fall dramatically in price.
Opportunities in flat markets
The price of an option is based on the time to expiry, the price of the underlying, the strike price, the volatility, and the prevailing interest rate. When market volatility is historically low, then the price to purchase options – both calls and puts – is less expensive than when volatility is high.
How would volatility impact the price of options?
Think about it this way: if the Nifty all of a sudden crashed 10% in a day, traders will want to do one of two things.
First, traders would buy put options on stocks to protect their portfolio against further downside. This higher demand for puts will drive up the price of put options and subsequently, the implied volatility of put options. A second thing that traders would do is buy call options speculating that the market will sharply bounce back. This higher demand for calls will increase the price, as well as the implied volatility, of call options. This increased implied volatility for both calls and puts will be reflected in the higher VIX value.
As the market has been on a generally steady incline, the opposite is essentially happening: Traders are less interested in buying puts to protect against downside equity movements and fewer traders are speculating on drastic upswings in the market. Broadly speaking, this lower demand leads to lower VIX values and thus, less expensive options. With the VIX being low, it presents us with a few opportunities.
Opportunity #1: If you believe that the market will continue to stay flat or move only small amounts, then a trader can earn yield through non-directional options strategies for ‘flat’ markets. These strategies include Iron Condors and Short Straddles/Strangles. Do note though, that because of the current low level of volatility, the yield that the trader will earn through these strategies will be less than when the market has higher volatility. However, if the market continues to stay relatively flat, these strategies could have a higher success rate than when the market is volatile.
Opportunity #2: If you believe that the market will be more volatile in the coming weeks than it is right now, then you can purchase non-directional options strategies for ‘volatile’ markets. Specifically, traders could purchase long straddles or long strangles. These options strategies offer a double benefit to traders in times of low volatility.
One, these strategies will pay out if the market moves substantially. Two, returns could also increase if volatility broadly increases from the current near-historic low levels.
Opportunity #3: If you own stocks that have options available for them and you are concerned that this stock could suffer from a loss in value – perhaps due to an upcoming earnings announcement or as a result of a market pullback – then you can take advantage of this low volatility environment. Specifically, you can purchase a put option on those stocks. Due to the lower market volatility, buying put options is cheaper than is usually the case.
Strategies Used for the Opportunity
How can you put this into practice? In this section, we will review the non-directional strategies that you can use to earn yield, speculate on an increase in market movement, and protect your stocks against downside movements at a lower price than what is typically available. If you are comfortable with straddles, strangles, iron condors, iron butterflies, and protective puts, then you can skip this section. The subsequent section provides you with examples using recent market data to illustrate the current market opportunities.
Straddles & Strangles
There are non-directional strategies that allow the trader to make bets on the underlying index or stock becoming more volatile or moving around more. For example, if you believe that the current calm of the markets will end soon and give way to more drastic swings on a day-to-day basis, then you could enter into an options strategy focused on ‘volatility’. These strategies typically involve buying both calls and puts at the same time with the same expiration date. Examples of these strategies include long straddles and long strangles.
The only difference between a straddle and a strangle is the strike price. A straddle involves buying a call and a put option with the same strike price (and same expiration date). A strangle involves buying a call and a put option with different strike prices but with the same expiration date.
Long Straddles
- Construction: Long At-the-Money Call, Long At-the-Money Put
- Max Gain= Price of Underlying - Strike Price of Long Call - Net Premium Paid OR Strike Price of Long Put - Price of Underlying - Net Premium Paid
- Break-even Point 1= Strike Price + Premium Paid
- Break-even Point 2=Strike Price – Premium Paid
- Max Loss= Premium Paid for buying the call and the put
- Payoff Diagram:
Long Strangles
- Construction: Long Out-of-the-Money Call, Long Out-of-the-Money Put
- Max Gain= Price of Underlying - Strike Price of Long Call - Net Premium Paid OR Strike Price of Long Put - Price of Underlying - Net Premium Paid
- Break-even Point 1= Call Strike Price + Premium Paid
- Break-even Point 2= Put Strike Price – Premium Paid
- Max Loss= Premium Paid for buying the call and the put
- Payoff Diagram:
Iron Condors & Butterflies
There are also non-directional strategies that allow the trader to make best on the underlying index or stock staying calm or not moving. These strategies typically involve selling both calls and puts at the same time with the same expiration date. Since you are selling calls and puts, you can reduce your risk by hedging through purchasing of corresponding calls and puts. Examples of hedged strategies include Iron Condor and Iron Butterflies. As with straddles and strangles above, the difference between Iron Condor and Iron Butterflies is the strike price.
Iron Condors involve shorting call and put options with different strike prices (with the same expiration). Iron Butterflies involve shorting call and put options with the same strike prices (and the same expiration).
Iron Condor
- Construction: Short Out-of-the-Money Put, Long Out-of-the-Money Put (lower strike), Short Out-of-the-Money Call, Long Out-of-the-Money Call (higher strike)
- Max Gain= Net Premium Received
- Break-even Point 1= Strike Price of Short Call + Net Premium Received
- Break-even Point 2= Strike Price of Short Put - Net Premium Received
- Max Loss= Strike Price of Long Call - Strike Price of Short Call - Net Premium Received
- Payoff Diagram:
Iron Butterfly
- Construction: Short At-the-Money Put, Long Out-of-the-Money Put, Short At-the-Money Call, Long Out-of-the-Money Call
- Max Gain= Net Premium Received
- Break-even Point 1= Strike Price of Short Call + Net Premium Received
- Break-even Point 2= Strike Price of Short Put - Net Premium Received
- Max Loss= Strike Price of Long Call - Strike Price of Short Call - Net Premium Received
- Payoff Diagram:
Stock & Options Combinations
Lastly, a trader can marry a put option to a stock to act as a hedge. Here, a trader would purchase a put option associated with a stock that has 1-month to expiry. The strike price of such an option could be something such as 5% below the current stock price. In this case, so long as that option contract doesn’t expire, the trader cannot lose more than 5% on the stock. For example, assume a trader has a 5% out-of-the-money put option on Tata Motors which they also own. If this stock has a bad earnings announcement and opens down 8%, any loss of more than 5% will be offset by a gain in the value of the put option.
Protective Puts
- Options are traded as contracts of 50 units or lots. So, for every 50 shares of stock, the trader should purchase 1 put contract if they are interested in a ‘protective put’ hedge.
- Max Gain= Price of Underlying – Purchase Price of Underlying – Premium Paid
- Max Loss= Premium Paid + Purchase Price of Underlying - Put Strike
- Payoff Diagram:
Practical Examples
Let’s put this into practice and explore a few real-life examples of how these strategies could work.
Opportunity #1 Example: If you believe that the market will stay flat with low volatility in the next 1-2 weeks.
Nifty 50 closing price as of 2 December 2022: 18,696.10
Example Option Strategy #1: Iron Condor
- Expiration Date: 15 December 2022
- Strategy Construction: Trader collects a net premium of ₹50.20
- Sell Put with strike price of 18,500 for premium of ₹70.20
- Sell Call with strike price of 18,900 for premium of ₹90.05
- Buy Put with strike price of 18,500 at cost of ₹50.05
- Buy Call with strike price of 19,000 at cost of ₹59.55
- Max gain is the premium collected of ₹50.20
- Max loss is -₹49.80
- Max gain occurs as long as the Nifty stays between -1.1% and +1.1% on 15 December.
Example Option Strategy #2: Iron Butterfly
- Expiration Date: 8 December 2022
- Strategy Construction: Trader collects a net premium of ₹80.60
- Sell Put with strike price of 18,700 for premium of ₹87.95
- Sell Call with strike price of 18,700 for premium of ₹111.60
- Buy Put with strike price of 18,600 at cost of ₹50.95
- Buy Call with strike price of 18,800 at cost of ₹68.00
- Max gain is the premium collected of ₹80.60
- Max loss is -₹19.40
- Max gain occurs as long as the Nifty closes at 18,700 on 8 December.
Opportunity #2 Example: If you believe that there is a ‘buying opportunity’ and that volatility will rise within the next 1-2 months.
Nifty 50 closing price as of 2 December 2022: 18,696.10
Example Option Strategy #1: Long Straddle
- Expiration Date: 29 December 2022
- Strategy Construction: Trader pays a premium of ₹479.95
- Buy Put with strike price of 18,700 at a cost of ₹181.95
- Buy Call with strike price of 18,700 at cost of ₹298.00
- Max gain is unlimited
- Max loss is -₹479.95
- The trader becomes profitable if the Nifty closes above +2.6% or below -2.6% from the current price of 18,696.10 by 29 December.
Example Option Strategy #2: Long Strangle
- Expiration Date: 25 January 2022
- Strategy Construction: Trader pays a premium of ₹568.55
- Buy Put with strike price of 18,500 at a cost of ₹205.65
- Buy Call with strike price of 18,900 at cost of ₹362.90
- Max gain is unlimited
- Max loss is -₹775.00
- The trader becomes profitable if the Nifty closes above +4.1% or below -4.1% from the current price of 18,696.10 by 25 January.
Opportunity #3 Example: If you believe that you need to protect your equity holdings against a sudden drop in value and you want to take advantage of relatively lower priced options.
Reliance closed at 2,727.00 on 2 December 2022
The Put option with a 2,500-strike price expiring in 3-months (23 February 2023) is trading at ₹26.00. Owning this put option would protect against downside moves of 8% or more for a period of three months. This is because the strike price of 2,500 is approximately 8% below the current price of 2727.00. If the price of Reliance falls below 2,500, then the put option will be in-the-money. The increase in value of the put option will offset any reduction in price of Reliance below 2,500. The effective cost of this protection is 1% (26.00 / 2727.00). This means that you are giving up 1% to guarantee that you cannot lose more than 8% in the next quarter.
By comparison, Reliance closed at 2,283.95 on 25 February 2022. The put option with a comparable 8% protection for 3 months traded for ₹70.00. So, 9 months ago, the effective cost of this same level of protection was 3.1% (70.00 / 2283.95). The lower market volatility means that you can purchase put options to protect your equity holdings at a fraction of the cost several months in advance.
Conclusion
Option strategies are at their most effective in market situations like the one we are experiencing in India today. The surge, though welcome, has also prompted many investors to question whether the markets will peak out or rise further. Thus, as shown above, a well-thought-out options strategy could be a good bet to protect one’s investments in such a scenario.