Options an optimal way to handle poll-like scenarios

A strangle is a put below the spot price and a call above the spot. It is less expensive than a straddle, but it will not deliver profit unless there is a large movement

The next 12 months will feature multiple elections and those will trigger market volatility. Elections are price-sensitive events, but they are also “known unknowns”. In other price-sensitive events, “smart money” creates early trends. For example, people can make good guesses about central bank policy; there are the Budget leaks; industry insiders know if a company has a good quarter and so on.

There is no “smart money” in free and fair elections since outcome is unknown. Even assuming a trader guesses right about the winner, nobody knows if a political party will stick to its stated manifesto. Hence, election results create high levels of uncertainty and volatility.
 

The best way to play such situations is via index options. Many types of common spreads can be useful. Taking the Karnataka situation as an example, let's see how three types of spreads would have worked in day-trades. 

Two types of common spreads, straddles and strangles - cater for large moves in either direction. A straddle is a put and a call taken at the same strike price. If the market moves in either direction, one option gains while the other loses. 

On May 15, the Nifty opened at 10,812 with the futures at 10,814, just over an hour after counting started. The 10,800p (120) and 10,800c (118) straddle cost 238 at opening. By around 10.30 am, the call was trading at 180, while the put had fallen to 80. A cashout then would have been a quick 8 per cent profit.

The futures peaked at 10,947, and fell back to 10,787. The call hit a high of 190 and the put hit a high of 126. The call hit a low of 100, while the put hit a low of 50. At close, the call was at 111, the put at 95. The price moved in different directions with the call peak almost coinciding with the put low.

There was a long period during the day, when a trader with a long straddle could have cashed out at a profit. A trader (who expected a hung assembly) and sold the straddle could have cashed out a big profit at close. 

A strangle is a put below the spot price and a call above the spot. It’s less expensive than a straddle, but it will not deliver profit unless there’s a large movement. Say, a trader decided to buy a 10,900c (79), 10,700p (84) at the opening. This costs 163.

By 10.30 am, the 10,900c traded at 110, while the put fell to 62. Cashout would have been about 5 per cent profit. The call peaked at 123, the put peaked at 89. The call hit a low of 54, the put hit a low of 33. The long strangle was profitable for a smaller time-period and it had deeper losses than the straddle.

A third type of spread, the butterfly, can exploit situations of limited movement. For example, say a trader believed that the market would move between 10,800 and 11,000. He could take a long 10,800c (118), two short 10,900c (2 x 79) and a long 11,000c (38) at opening. This is an inflow of 2. The maximum profit on this position would have come when the index was at 10,900. At close, the position could be reversed with a short 10,800c (111), two long 10,900c (2 x 61.5), and a short 11,000c (28.5) with a further inflow of 16.5. 

There are many other ways to use options to exploit volatility caused by election-scenarios and position traders will set up such positions across several sessions rather than just use them to day-trade. Obviously there are no guarantees. But, options are the optimal way to handle typical election-related scenarios and these opportunities will pop up many times over the next 12 months.