Can you benefit from Market Volatility using a simple, low risk derivative strategy?

The broker said the stock was "poised to move." Silly me, I thought he meant up. -- Randy Thurman

How many times have you lost money on a trade because you missed the market direction?

You aren’t alone if you couldn’t count the number of instances.

Predicting market direction is the toughest task.

For example, elections are around the corner and experts and self-proclaimed experts both are expecting markets to remain highly volatile.

This time it’s elections, a few months later it could be something else. But, market volatility is a reality, right?

Why not bet on the volatility rather than betting on the direction then?

We toyed with the idea to check if there was any merit in this thought.

Not so to our surprise, we devised a ready-to-implement strategy.

Here’s what we did (in a nutshell)

Base product: Nifty50

Time frame: We back tested the strategy over a period of the most recent 5 years (60 months) from January 2014 to December 2018.

Strategy: The long straddle: We purchased one at-the-money call option and one at-the-money put option. In this strategy, the profit possibility is unlimited and the maximum loss is limited to the purchase price of both the options into the lot size.

Approximate investment required: At the outer limit, an investment of around Rs 12,000-13,000 was required for a period of around a week to construct the strategy every month.

Strategy entry every month: Initiate the strategy on the Friday before expiry, i.e. 4 working days before the options expire.

There were three distinct reasons for this choice:

• In our experience, just before expiry, the premiums on both options are almost depreciated and therefore relatively low.
• Further, the last few days before the expiry are usually characterised by some volatility and this facilitates returns on the strategy.
• Last, but not the least, it involves blocking capital for just 5-7 days

Exit from the strategy every month: Instead of trying to gauge the best time to exit, we tested four scenarios.

Each of these would deliver different risk-return results. In the first case, after setting up the strategy, we waited for a profit of just Rs 25 from the strategy, i.e. a total of Rs 1,875 from purchasing one call on Nifty50 (one lot) and one put on Nifty50 (one lot). As soon as this level was reached, we would exit the strategy, irrespective of how many days were left until expiry. If the profit target was not reached, we held the strategy positions till expiry.

Similarly, we tested three other scenarios, where we waited for a profit target of Rs 50, Rs 75 and Rs 100, respectively, before expiry; if these targets were not achieved, we held the positions till expiry.

Essentially, while all four scenarios had a common entry, the exit would be triggered if the profit target was reached or expiry, whichever came first.

Naturally, the profit target of Rs 25 was achieved most often, followed by the target of Rs 50, then Rs 75 and least often, Rs 100.

Recapping: Our four scenarios were…

• Scenario 1 (minimum risk): Profit target of Rs 25
• Scenario 2 (low risk): Profit target of Rs 50
• Scenario 3 (medium risk): Profit target of Rs 75
• Scenario 4 (relatively high risk): Profit target of Rs 100

Our Study Results:

Scenario 1 (minimum risk): Profit target of Rs 25

• 82% success and 18% negative outcome: Of the 60 data points, 49 times the strategy closed positively and 11 times the strategy closed negatively.
• Profit of Rs 41,136 over the entire five year period (for year by year results, please see the table)
• The profit is around 3.16 times the investment of about Rs 13000

Scenario 2 (low risk): Profit target of Rs 50

• 67% success and 33% negative outcome: Of the 60 data points, 40 times the strategy closed positively and 20 times the strategy closed negatively.
• Profit of Rs 49,931 over the entire five year period (for year by year results, please see the table). Waiting for a higher profit target meant less successful outcomes but overall delivered higher profit, confirming the higher risk – higher return maxim.
• The profit is around 3.84 times the investment of about Rs 13,000

Scenario 3 (medium risk): Profit target of Rs 50

• 63% success and 37% negative outcome: Of the 60 data points, 38 times the strategy closed positively and 22 times the strategy closed negatively.
• Profit of Rs 70,888 over the entire five year period (for year by year results, please see the table). Once again waiting for a higher profit target meant less successful outcomes but overall delivered higher profit, confirming the higher risk – higher return maxim.
• The profit is about 5.45 times the investment of around Rs 13000

Scenario 4 (high risk): Profit target of Rs 100

• 62% success and 38% negative outcome: Of the 60 data points, 37 times the strategy closed positively and 23 times the strategy closed negatively.
• Profit of Rs 82,465 over the entire five year period (for year by year results, please see the table). Yet again waiting for a higher profit target meant less successful outcomes but overall delivered higher profit, confirming the higher risk – higher return maxim.
• The profit is around 6.34 times the investment of around Rs 13,000

Caveat: These figures are excluding brokerage and other charges. However, if we were to include the brokerage, other charges and the cost of capital, it would amount to around Rs 4000-5000 for the entire 5 year period.

Interestingly, we back-tested the same strategy on Bank Nifty for a period of five years and saw similar result trends.

In conclusion, we are happy to say that with this strategy, you do not have to time the market to benefit from it. All it takes is discipline to invest a small amount (of course, if you are not satisfied with one lot, you can purchase more) once a month over the long term.

With our conviction in Sabse bada rupaiya we believe that

Investors benefit when markets go up.

Traders benefit when markets trend.

But smart traders benefit when markets move in either direction.

What we have shared with you is only one aspect of a more detailed study that our derivatives research team conducted. Do connect with us at blogcontent@ventura1.com if you would like to know more about the results of the entire study.

Disclaimer:

We, Ventura Securities Ltd, (SEBI Registration Number INH000001634) its Analysts & Associates with regard to blog article hereby solemnly declare & disclose that:

We do not have any financial interest of any nature in the company.

We do not individually or collectively hold 1% or more of the securities of the company.

We do not have any other material conflict of interest in the company.

We do not act as a market maker in securities of the company.

We do not have any directorships or other material relationships with the company.

We do not have any personal interests in the securities of the company.

We do not have any past significant relationships with the company such as Investment Banking or other advisory assignments or intermediary relationships.

We are not responsible for the risk associated with the investment/disinvestment decision made on the basis of this blog article.