Four different ways to play markets when you are unsure of the direction

Options give you the opportunity to trade with limited risk. For example, when you are bullish on the stock or the index, you can buy a call option and when you are bearish you can buy a put option. In case you are moderately bullish or moderately bearish, you have strategies like a bull call spread or a bear put spread respectively. But all these strategies are fine when you have a

view on the direction of the market. What if your view is that the direction of the market cannot be known? Is there is a strategy for that? Firstly, what do we mean by directionless markets?
 

Two ways to look at a directionless market
 

You can either look at a directionless market as a volatile market or as a range-bound market. Volatile markets can be volatile in either direction i.e. on the upside or on the downside. The only key takeaway in volatile market is that the volatility as measured by the standard deviation is increasing. The markets may be at the cusp of a major breakout but you are not sure of the direction.

The second is a lacklustre market which is range bound in a small range. Here the volatility is falling sharply and that means the market is going to be in a very narrow range. Just as you can buy calls when you are bullish and puts when you are bearish, you can combine the two when you are in a directionless market.
 

Four different ways to play markets when you are unsure of the direction
 

1. Long straddles and short straddles when you expect shifts in volatility
 

In a straddle you buy the call option and a put option of the same strike price. Effectively, you are betting that the market index or the stock is going to give a breakout but you are not sure which direction this breakout will happen. Let us say Infosys 750 call option is quoting at Rs.25 and the Rs.750 put option is quoting at Rs.28 when the current market price of Infosys is Rs.747. You can create a straddle by buying one lot of 750 call option and one lot of 750 put option.

The total cost of the straddle is Rs.53 (25 + 28), the sum of the premiums of the call and the put. You will be profitable either if the stock price of Infosys goes above Rs.803 or if it goes below Rs.697. When either of these limits is breached your straddle becomes profitable. You are betting on volatility not on the direction of Infosys price movement. 

If your view is range bound you just reverse the strategy. If you expect Infosys to be range bound you can sell this straddle. As long as the stock stays in the price range of Rs.697 and 803, you are going to be profitable on the short straddle. Remember, short straddles are open-risk strategies as outside this range your losses can be unlimited. Also short straddles entail initial

margins and MTM margins when the market moves against you.
 

2. Tweak your costs with a strangle instead of a straddle
 

A slight improvement of the straddle is the strangle strategy. In a long straddle you buy the call and the put of the same strike price. On the contrary, in a strangle strategy you buy a call of a higher strike and put of a lower strike. This offers two advantages. Since you are widening the gap between the call strike and the put strike your premium cost comes down. Secondly, when you are expecting range bound markets, a short strangle will give you a much wider protection range as compared to a straddle.

In real markets, strangle strategy is a lot more popular than straddles as there are more strangle sellers than straddle sellers.
 

3. You can also use a multi-leg long Butterfly spread strategy
 

Butterfly strategy combines selling 2 ATM options and simultaneously buys 1 ITM option and 1 OTM option. The net result is a small debit which is the maximum cost of the butterfly spread strategy. However, that there are 4 legs to a butterfly strategy and 4 legs at the time of closure of the strategy, making it a total of 8 legs.

There is transaction cost and statutory cost implications and that needs to be factored into your breakeven point calculations.
 

4. Extending the butterfly strategy into a condor strategy
 

A Condor is basically an extension of the butterfly strategy. The only difference is that instead of selling 2 ATM options, the strategy sells 1 ITM option and 1 OTM option. Again, there are a total of 8 legs in initiating and closing out this transaction which adds substantially to the cost. Also, the net flow can be quite complicated in such cases. Next time you are up against volatile markets or range bound markets, don’t start fretting. Combination of call and put options can be structured in such a way as to best capitalize on such directionless markets. Make the best of it.

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Disclaimer: The above opinion is that of Ms. Sneha Seth (Derivatives Analyst - Angel

Broking) & is for reference only.