Trading amid uncertainty

Experimentation requires high risk-appetite and the confidence to repeat it again.

“Mark Twain once pointed out: “October: This is a particularly dangerous month to invest in stocks. Other dangerous months are July, January, September, April, November, May, March, June, December, August and February.”

Humour aside, different months and indeed, days of the week, can have distinct historical volatility. Studies suggest Mondays and Fridays are more volatile than mid-week. Late February- early March is high volatility because of the Budget.

Another interesting period is late December-early January. December 31 is the fiscal-end for Foreign institutional investors (FIIs). In January, FIIs tend to be more active. That activity can lead to trends being established for at least a few weeks.

Since 2011-12 may see big bang tax reform, it's possible the FIIs will be more inclined to fence-sit through January and wait for the Budget. But there's still a somewhat enhanced chance of big swings in early-mid January. The direction cannot be predicted with confidence though not too many signals are positive. In addition to rising interest rates, multiple scams could mean political instability.

A pure investor can do little except perhaps hedge, via deep long puts. Option traders can look to bet non-directionally on high volatility. January is a good time for “zero delta” positions. “Delta” is the amount by which an option premium changes for every unit change in the underlying.

A zero-delta position is one where opposed options cancel out. Options with strikes equidistant from money have the same deltas. Long calls are positive delta (they gain as underlying rises)and long puts are negative delta (gain as underlying falls).

Close-to-money (CTM) index options premiums are usually one to two per cent of underlying value with premium dropping below 0.2 per cent, far-from-money (FFM). Hence, even small deltas mean massive leveraged gains or losses. For example, say a premium has 0.25 delta - it gains 0.25 for every one unit gain in underlying. If the premium is 1.5 per cent of underlying, (leverage of 66:1), then a one per cent change in underlying means roughly 16 per cent change in premium.

Zero-delta positions can gain regardless of direction because delta itself changes. As strikes move closer to money, the delta increases. When further from money, the delta decreases. Say, a long strangle is taken at the money with a long call and a long put that have the same strikes.

Such a long straddle is zero-delta since the call-put combination cancel. The option that goes into the money, will gain more than is lost by the option moving away from the money. Suppose the underlying rises. Then,the call delta rises and call premium jumps, while the put delta falls and the put premium declines. But call premium will rise more than the put premium will decline. Vice-versa, if the underlying falls, the put premium will gain more than the call loses.

January is an ideal month for cheap, long strangles FFM. For example, a trader hoping for a 10 per cent move, may look at opposed strikes 500 points from spot. With the underlying Nifty at 6,011, this is a long January 6,500c (premium:10) and a long January 5,500p (13) These have equal deltas, in the region of 0.01 and cost about 0.2 per cent of underlying.

The cost of 23 is reduced by selling the January 5,400p (9) and the January 6,600c (5) for a net cost of 9. The combination is still zero-delta. If the market moves beyond breakeven at 5491, 6509, the maximum theoretical gain at January settlement (27/01/2011) would be 91. In practice, if either option is struck, it will jump to about two per cent of underlying and can be reversed for even greater returns than 10:1.

How likely is a 10 per cent Nifty move in a single settlement? It’s happened 11 times in the last 120 months. So, the chances are about nine per cent - once in 11 tries. If it does occur, the net payoff is positive. The trader expects to lose a maximum of 90 (9x10) on ten occasions, when the market stays within the 5,500-6,500 band - he will actually be able to settle for somewhat lower losses. He hopes to gain 100-odd if it does swing beyond.

This position is high-risk but slightly more likely to work in January for the above reasons. If you are comfortable with the strategy, you should be prepared to repeat it if January doesn’t work. The main barrier to using this method is psychological. Do you have the nerves to bet small sums, going with the odds and accept that you will lose money most of the time?