Making money from volatility

INSIGHT

Coming into a settlement, any derivatives trader must note potential arbitrage opportunities. Thanks to high-speed computers, the price differentials between contracts in different timeframes (May futures versus June futures), triggered by carry over, get cleared before a retail trader notices these.

But some arbitrage situations peculiar to settlements remain. One is the distortion caused by expiry effects versus heightened volatility. Options that are off-the-money lose premium value as expiry draws near. But the compulsion to clear or carry over outstanding positions, etc, also causes higher price volatility and very high volumes close to expiry.

Often implied volatility (as represented by option premia) is low, while historical volatility is high. This can present a major opportunity when a far-from money option trades cheap, while the historical volatility suggests it has a high probability of being struck.

These situations are stressful to trade. The opportunity may be fleeting and the trader has to be alert enough to reverse the instant the situation turns profitable. But these situations can also generate multi-bagger returns within a couple of sessions.

Here's a typical situation. In the past six months, the Nifty has, on average, traded 93 points (1.65 per cent) in its daily high-low range. The standard deviation is 39 points. Close to settlement, the chance of a big move of average plus two standard deviations (171 points) rises.

A trader who works out the basic statistics knows the Nifty has a high probability of ranging between (May 18 close of 5420 plus-minus 93) 5,327 and 5,513 on Thursday. He has some expectation that it may swing 132 points (average+1 SD) and a lower expectation of a 171-points swing (average+2 SD). Even the lowest of these moves would trigger big changes in option premia (put and calls) across strikes of 5,300, 5,400, 5,500.

The May 5,400c (premium 67) and 5,400p (43) are on the money. The 5,300p (15) and the 5,500c (27) are cheap. Delta calculations suggest if either of these off-the-money options is struck, it would at least double and maybe triple in value.

Say a long strangle of 5,300p and long 5,500c is taken, costing 42. If the market drops to near 5,300, the 5,300p will rise in value to around 40, while the 5,500c will drop to around 10. If it rises to 5,500, the 5,500c will rise to around 55, while the 5,300p will drop to about five.

Reversing the strangle in either circumstance would mean a return of anywhere from 15-50 per cent in a single session, if the market moves an average amount. If the market moves more than average, the returns could be much higher. If you can stomach the risks and watch prices continuously, this is a good trading strategy.

The author is a technical and equity analyst