What could be a good Nifty Options strategy to play the Union Budget that is to be presented tomorrow? A long straddle appears to have performed quite well over the last few years.
Before you read further, here are some dates to remember: 16th March 2012 (Friday) is the date of the Union Budget and 29th March 2012 (last thursday of the month) is the date of expiry of March 2012 Option contracts.
Union budgets may or may not be predictable. It could turn out to be positive for the market or in some cases negative. When we can't assess a definite direction for the market post budget, it's best we take a position that is completely independent of the direction itself. In other words, we don't need to care where the market is headed after the budget is announced but it would be great if it moves significantly for this strategy to work. However, historically the Nifty benchmark index has indeed moved quite a bit from the budget date to the next expiry date in either direction.
A long straddle is when you buy a Put Option and a Call Option of the same expiry and both at the same strike.
Now, lets jump in and look at the cost of the straddle and choice of strike, etc. to be taken. Currently, there are 51 different Nifty Option Contracts being traded which would expire in the month of March (near month contracts). Out of these, the ones with a strike price around the current Nifty Spot Index (called At The Money strikes) are highly liquid and the liquidity slowly dries out as the strike moves away from the spot in either direction. Lower the liquidity, higher the inefficiency in price determination. Meaning, we are ok having a strike that is even somewhat closer to the spot, but yes, we'd like it closer to the spot for the sake of sustained liquidity.
We're now going to see, firstly, how has this 'pre-budget straddle' worked in history, which strike to choose and why, when to book your profit/loss. Yeah, offcourse, there could be a loss. There is nothing called '100% probability of profit' in stock market. But, definitely we can identify strategies with bear minimum losses and with a good potential of profit.
How has the pre-budget straddle worked historically?
Answer to this question is the most important part of this read. To evaluate the performance of this strategy, we need to consider two dates, and the Nifty spot levels on these 2 dates. The first one is the day just before the 'budget-day' because, since you're strategy is based on this event called budget, and since option prices reduce with time due to the gravity of the greek, 'Theta', (Time-Value of Option prices) you dont want to pay a higher price taking the position some days before the budget. Rather, take it just the day before the event and save on time-value (Theta). And, the second date (the date on which you'd square off your position) could be 'the budget-day' (T0), the day next to the budget-day (T+1) or T+2 or T+3 or T+9 (T+9 is the expiry date, 29Mar2012) or even the expiry date of the contract (the last thursday of the month). The reason why I mentioned T+1, T+2, T+3, etc, is because it usually takes a few days, for the market to digest this huge information in the budget and it could actually end up giving a fair price to the stocks after some days of nervousness and jitters.
So, what should it be? T+1, T+2, ...? To determine this, let's take a look at the cost of the Option straddle, for which we should answer the following question.
Which of the 51 strikes (contracts) should I choose?
As I said before, or as we know it, a long straddle is buying a put option and a call option of the same strike and the same maturity, which means, our expense is going to be the sum of the cost of both the options. Among the Nifty options as on 14Mar2012, the cheapest straddle is the one with the 5500 strike (Rs. 221.30). Here's the breakup; Nifty Mar2012 5500 Call = Rs. 114.8 and Nifty Mar2012 5500 Put = Rs. 106.5. And yesterday (14Mar2012) Nifty closed at 5463.90. Does it ring a bell? Well, it isn't a surprise. But, our beloved 5500 is the closest contract to the spot!
Now, let's see some simple maths. Rs. 221.3 can also be said as, 4.05% of the spot (221.30/5463.90). So, on the expiry date, if the spot is greater than 5721.30 (5500+221.30) which is a 4.71% increase from current price (5463.90) or if the spot is lower than 5278.70 (5500-221.30) which is a 3.39% decrease from the current price (5463.90) we'd be in the money, meaning profit. That is, the Nifty spot should have either decreased by 3.39% or increased by 4.71% for us to be in profit. Being direction neutral, meaning equal probability in either direction, the 4.71% increase is the tougher alternative of the 2. Would it change that much? We don't know. But we know a better question. Does it have to?? Although we're not bothered about what it is going to be on the expiry date, historically it has changed by more than 5% post-budget, either up or down, every time. Considering history (take a look at the table below), even the most difficult of the 2 cases, a +4.71% change, is an easy target!!
If the table is inspirational you can hold it upto maturity. But, read on to square it off before!
Just a reminder, we're yet to find out our second date (the square off date).
Assuming Nifty is at the same level 5 days before the expiry and on the expiry. The cost of the straddle at 5 days prior to expiry will be much higher than the cost of the straddle on the day of expiry due to the time value (5 days of Theta). In fact, the straddle could become profitable if Nifty has changed by just 4.25% at 5 days prior to expiry due to time value.
This means, the square off date shall fall within just a few days, not waiting until the expiry. In fact, T0 being a friday the participants have saturday and sunday to cool off post-budget and read the budget upto its fineprints. Also, with 29th March being the expiry date, unfortunately this year, we dont have much time before expiry post-budget (just 2 weeks) and Theta losses are very high during the last week. Considering these 2 factors, typically I'd choose the mid-week, i.e, T+3, 'The Wednesday' (21Mar2012) as my square off date. The strategy is nothing but making a safe bet on the budget.
Now, what if the market got nailed at where it was pre-budget and forgot the meaning of volatility? In that case, the Delta of the option would not have helped us as the market is stable, whereas we'd be losing on the Theta. So, it would be wise to square off your straddle booking a loss in 3 days which can't be too much, as there would still be good amount of Theta left and since budget-days are one of the most volumous days of the year, the volatility of the options immediately post budget would defnitely be high which would also keep option prices higher than at normal situations. So, T+3 is a reasonable amount of time for the market to give-in fairly to the effects of budget and at the same time not entering the last week of the contract to escape from the Theta devil.
In summary, take a Nifty Mar 2012 5500 Straddle (one lot should cost around Rs. 12000) on 15th March (Thursday), wait until 21Mar2012 (following Wednesday), before which you'd most likely see the happy-ending! ;)
Dhiraj Shekar
Before you read further, here are some dates to remember: 16th March 2012 (Friday) is the date of the Union Budget and 29th March 2012 (last thursday of the month) is the date of expiry of March 2012 Option contracts.
Union budgets may or may not be predictable. It could turn out to be positive for the market or in some cases negative. When we can't assess a definite direction for the market post budget, it's best we take a position that is completely independent of the direction itself. In other words, we don't need to care where the market is headed after the budget is announced but it would be great if it moves significantly for this strategy to work. However, historically the Nifty benchmark index has indeed moved quite a bit from the budget date to the next expiry date in either direction.
A long straddle is when you buy a Put Option and a Call Option of the same expiry and both at the same strike.
Now, lets jump in and look at the cost of the straddle and choice of strike, etc. to be taken. Currently, there are 51 different Nifty Option Contracts being traded which would expire in the month of March (near month contracts). Out of these, the ones with a strike price around the current Nifty Spot Index (called At The Money strikes) are highly liquid and the liquidity slowly dries out as the strike moves away from the spot in either direction. Lower the liquidity, higher the inefficiency in price determination. Meaning, we are ok having a strike that is even somewhat closer to the spot, but yes, we'd like it closer to the spot for the sake of sustained liquidity.
We're now going to see, firstly, how has this 'pre-budget straddle' worked in history, which strike to choose and why, when to book your profit/loss. Yeah, offcourse, there could be a loss. There is nothing called '100% probability of profit' in stock market. But, definitely we can identify strategies with bear minimum losses and with a good potential of profit.
How has the pre-budget straddle worked historically?
Answer to this question is the most important part of this read. To evaluate the performance of this strategy, we need to consider two dates, and the Nifty spot levels on these 2 dates. The first one is the day just before the 'budget-day' because, since you're strategy is based on this event called budget, and since option prices reduce with time due to the gravity of the greek, 'Theta', (Time-Value of Option prices) you dont want to pay a higher price taking the position some days before the budget. Rather, take it just the day before the event and save on time-value (Theta). And, the second date (the date on which you'd square off your position) could be 'the budget-day' (T0), the day next to the budget-day (T+1) or T+2 or T+3 or T+9 (T+9 is the expiry date, 29Mar2012) or even the expiry date of the contract (the last thursday of the month). The reason why I mentioned T+1, T+2, T+3, etc, is because it usually takes a few days, for the market to digest this huge information in the budget and it could actually end up giving a fair price to the stocks after some days of nervousness and jitters.
So, what should it be? T+1, T+2, ...? To determine this, let's take a look at the cost of the Option straddle, for which we should answer the following question.
Which of the 51 strikes (contracts) should I choose?
As I said before, or as we know it, a long straddle is buying a put option and a call option of the same strike and the same maturity, which means, our expense is going to be the sum of the cost of both the options. Among the Nifty options as on 14Mar2012, the cheapest straddle is the one with the 5500 strike (Rs. 221.30). Here's the breakup; Nifty Mar2012 5500 Call = Rs. 114.8 and Nifty Mar2012 5500 Put = Rs. 106.5. And yesterday (14Mar2012) Nifty closed at 5463.90. Does it ring a bell? Well, it isn't a surprise. But, our beloved 5500 is the closest contract to the spot!
Now, let's see some simple maths. Rs. 221.3 can also be said as, 4.05% of the spot (221.30/5463.90). So, on the expiry date, if the spot is greater than 5721.30 (5500+221.30) which is a 4.71% increase from current price (5463.90) or if the spot is lower than 5278.70 (5500-221.30) which is a 3.39% decrease from the current price (5463.90) we'd be in the money, meaning profit. That is, the Nifty spot should have either decreased by 3.39% or increased by 4.71% for us to be in profit. Being direction neutral, meaning equal probability in either direction, the 4.71% increase is the tougher alternative of the 2. Would it change that much? We don't know. But we know a better question. Does it have to?? Although we're not bothered about what it is going to be on the expiry date, historically it has changed by more than 5% post-budget, either up or down, every time. Considering history (take a look at the table below), even the most difficult of the 2 cases, a +4.71% change, is an easy target!!
| Year | Budget Date (T0) | % Chg from T0 to ExpDate |
| 2011 | 28-Feb-11 | 6.6% |
| 2010 | 26-Feb-10 | 8.7% |
| Jul-09 | 6-Jul-09 | -10.2% |
| Feb-09 | 16-Feb-09 | -7.3% |
| 2008 | 29-Feb-08 | -14.8% |
| 2007 | 28-Feb-07 | -7.3% |
| 2006 | 28-Feb-06 | 11.5% |
| 2005 | 28-Feb-05 | 5.2% |
| 2004 | 28-Feb-04 | -6.4% |
If the table is inspirational you can hold it upto maturity. But, read on to square it off before!
Just a reminder, we're yet to find out our second date (the square off date).
Assuming Nifty is at the same level 5 days before the expiry and on the expiry. The cost of the straddle at 5 days prior to expiry will be much higher than the cost of the straddle on the day of expiry due to the time value (5 days of Theta). In fact, the straddle could become profitable if Nifty has changed by just 4.25% at 5 days prior to expiry due to time value.
This means, the square off date shall fall within just a few days, not waiting until the expiry. In fact, T0 being a friday the participants have saturday and sunday to cool off post-budget and read the budget upto its fineprints. Also, with 29th March being the expiry date, unfortunately this year, we dont have much time before expiry post-budget (just 2 weeks) and Theta losses are very high during the last week. Considering these 2 factors, typically I'd choose the mid-week, i.e, T+3, 'The Wednesday' (21Mar2012) as my square off date. The strategy is nothing but making a safe bet on the budget.
Now, what if the market got nailed at where it was pre-budget and forgot the meaning of volatility? In that case, the Delta of the option would not have helped us as the market is stable, whereas we'd be losing on the Theta. So, it would be wise to square off your straddle booking a loss in 3 days which can't be too much, as there would still be good amount of Theta left and since budget-days are one of the most volumous days of the year, the volatility of the options immediately post budget would defnitely be high which would also keep option prices higher than at normal situations. So, T+3 is a reasonable amount of time for the market to give-in fairly to the effects of budget and at the same time not entering the last week of the contract to escape from the Theta devil.
In summary, take a Nifty Mar 2012 5500 Straddle (one lot should cost around Rs. 12000) on 15th March (Thursday), wait until 21Mar2012 (following Wednesday), before which you'd most likely see the happy-ending! ;)
Dhiraj Shekar
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