In an earlier blog, we had explained how short strangles work – which attempt to eke out a reasonably interesting annual return. With volatility now having risen substantially, straddles have found popularity as traders bet on large moves in either direction and don’t mind “paying” a premium to participate either side. Remember straddles are essentially a “Heads I win – Tails I win” strategy- meaning any direction of move is welcome as long as there is a large movement! But they are costly as this “right to buy or sell” not cheap in Corona times.
Given that a lot of portfolios are damaged substantially, and another strategy that leaks cash like the Long Straddle/Strangle may not be interesting, there are times that one could look at earning cash on an underlying portfolio while creating a trade that minimizes risk of loss.
Portfolio investors may use the Short Straddle strategy combined with a put purchase in time so high volatility – in the best case scenario, earning good income and in worst times, not losing much. We present a simple strategy for the same in this brief writeup below.
What are Short Straddles
A short straddle is essentially a decision to sell a CALL and sell a PUT option , same strike price and same expiry. Normally, a trader would do this assuming that the markets wont move in any direction by much and will pocket the “premium”. However, these are not normal times – volatility is at very high levels and therefore, prices of options are ruling high – and one could make some good money by selling these.
The scare factor however – irrespective of which way the markets move, this trade starts to lose money almost immediately so you need to have a good buffer of credit / premium from the trade before you enter negative return territory.
Lets say you markets are at 8000 levels on the Nifty currently and you are in the following setup:
- Volatility is very high and its likely that holidays and trading weeks may crunch trading time during the month (This results in faster decay of premia but don’t worry about the math)
- You believe that the market is likely to remain between 7000 and 9000 levels by April 30, 2020
- You want to make money in this situation – using your underlying portfolio as margin.
- However, anything can go wrong and you don’t want to lose a lot of money if markets drop below 7000 – and if markets go up above 9000 , you are ok as you have an underlying portfolio which will also gain at a at least the same rate as Nifty.
If you are an investor (Traders will smirk at this idea because selling straddles doesn’t make sense if you don’t have a portfolio) with the above thought process, a “fortified” Short Straddle makes sense.
Implementing the Trade
As of April 3, 2020, the Call Options on 8000 Nifty and Put Options on 8000 Nifty are trading at about Rs 475 each meaning you can earn about Rs 950 by selling one of each. On a margin of about Rs 2.4 lakh – since you are a seller in two options, margins are required where you can put up your existing stock portfolio– you get an upfront credit of Rs 73,000 in your account. – a 30% return to begin with!
Your maximum profit on expiry – meaning on April 30,2020 – will be if markets expire at Rs 8000 levels. No movement happened so no risk – and what you sold to someone was worthless to him as the markets didn’t move. But that’s the best case scenario.
What happens if the markets drop to 6000 levels. In that case, you earned Rs 950 upfront but the Put Option you had sold at 8000 levels would expire in a loss of Rs 2000 (8000-6000) – meaning a net loss of Rs 1050 – a much larger loss of 32% on the margin invested.
A similar thing happens if markets rise to 10,000 as you lose 32% here as well – but in this case you had an underlying portfolio which gained as well so you needn’t worry much. It was a price you paid to ride over the uncertainty. Also, if this happens you may be able to exit the trade much earlier as volatility dropped but that’s technical so lets avoid that for the purpose of this blog .
Step 2: Handling the Downside
Lets say markets continue to drop – so you are losing portfolio value and in addition, now you have this silly trade to deal with! Adding to losses?
Not so! On April 3, 2020, the 7200 PUT option is trading at Rs 180 so you may buy that to protect against downsides. In that case , when markets drop below your breakeven point, your sold put is losing money from 7050 levels but your bought put is making money – thus removing the loss!
However, since you have paid premium upfront here , your net inflow now reduces from Rs 960 to Rs 780 – a 24% return when you set up your trade.
The Overall Situation
Once you have created this fortified setup of a short straddle, ask your dealer to start monitoring it. While direction will create risk to the underlying positions, reduction in volatility – if at all – will mean that the premiums are going down – remember you were a seller so markets are offering you an opportunity to buy back at lower levels.
Or if you are unlucky, the volatility may shoot up and the direction of markets may also take sharp turns – up or down. Up wont hurt if your portfolio is moving at least at the speed of the market and down you have already protected your strategy against – but of course your portfolio will continue to leak as values drop. But that would have happened anyway. You tried to make an extra return but it couldn’t happen, that’s all.
When to initiate a Short Straddle Options Trading Strategy?
You started with a 24% return as a buffer for all possible scenarios so you have essentially bought time – even if markets move against you, there is a high probability you may end up making some return – because
- Markets didn’t move beyond the 7000-9000 range OR
- Volatility came down before April 30, 2020 OR
- The strategy made money prior to expiry because of some announcement – either leading to rapid decline in volatility or rapid time decay (unexpected holodays or exchange shutdowns for example)
The important point to remember here however is that the trade discipline needs to be followed – while its ok to check on the prices with your dealer , don’t be in a hurry to be overactive – Don’t make mistakes like trying to time one part of the trade (example booking the put option on market declines) or having an underlying portfolio that doesn’t move with the Nifty – because in that case the Nifty may move higher – losing money on options – but your portfolio wont gain anything , adding to the pain.
The strategy is therefore ideal for investors who a) have a belief in the setup described above b) have a portfolio that will move with markets at least at same speed if not more (especially with top 10 nifty stocks and large financials) – called beta > 1, and c) have a minimum size of portfolio of Rs 6 lakh odd which is what the Nifty Options contract size is.