Guard your portfolio against volatility

Buy Nifty puts to reduce losses

Most market trades are zero-sum. The profits of one trader match the losses of the other (neglecting brokerage and leverage). Obviously this means the risks are the same for both. But options are asymmetric and these instruments change risk allocations.

The buyer of an option takes on strictly limited risk. The buyer's risk is always far lower than the option-seller's risk. The option buyer has the right but not the obligation to exercise an option. The seller must deliver on his commitment if the buyer chooses to exercise the option.

All options are time-bound. The seller receives a premium upfront and may have to fork out many multiples of the premium under carefully defined conditions. In theory, the option seller's loss could be infinite in some cases. The buyer's maximum loss is the premium and that is the seller's maximum gain.

Many investors are scared off because the concepts sound complex. Indeed, some options can be very complicated. Nobel prizes have been handed out for option pricing models and Nobel winners have gone bust in trading. However, every middle-class citizen buys a certain kind of option. By analogy, they should be comfortable with other standardised options.

Insurance is based on options. What the insurance policy structure may be, the insurer is liable for many multiples of the premium paid over a given timeframe. Insurance was conceptualised as a way to offset risk and it has been among the fastest-growing industries for several centuries. Arguably, it was a key underpinning of the industrial revolution and even earlier, of European exploration expeditions. It allowed factory owners to offset the risks of accidents and allowed ship owners to send ships into unknown waters.

Other types of options on underlying financial assets can also be used as risk-management tools like with insurance. They are especially useful in situations where the trader is aware that there could be violent moves in either direction.

The May settlement period certainly qualifies as likely to be volatile. Election results will come through on May 16. There could be several possible outcomes to the election and each is guaranteed to create different trends in the stock market. The settlement ends on May 29, which gives the market ample time to exhibit manic-depressive behaviour.

First scenario, the BJP may indeed enjoy a Modi-wave and log enough seats to put together a stable coalition. If it does, the market will zoom up. Second, the BJP may land up being the single largest party (this seems a given) and put together a coalition after taking a little time and trouble. In that case, the market could see dramatic ups and downs until the horse-trading is done and the new government has been installed. In a third scenario, the BJP is forced to make large concessions to a dubious set of allies and the market responds by heading down. In a fourth scenario, the market crashes with steep losses because the BJP cannot stitch together a government.

The trader may assume that the major market index, the Nifty, could move up by over five per cent before the May settlement ends on May 29 if there's a favourable outcome. It could also fall by 5 per cent if there's an unfavourable outcome.

Using options a trader could cover both those possibilities by buying calls and puts on the Nifty with strikes at three to four per cent distance from the current Nifty levels. The cost of these options would be roughly 1.5 per cent of the strike. That is, for a strike of say, 7,000, the option premium would be around 100-105.

Combined, the cost of the position with a long call and a long put would work out to about 3 per cent of the current index levels. If either option was struck with about 5 sessions to go for settlement, the return would be at least 100 per cent over premium deployed. It could be a great deal more depending on election outcome.  An investor need not guard against two-way volatility. He can protect his portfolio against losses by buying Nifty puts. The efficiency of this hedge depends on the given portfolio's correlation and sensitivity to the index.

The strategy of buying distant options can be called "buying volatility". The assumption is that the market will see higher volatility going forward and that this is insufficiently discounted by the current premiums. General elections are unusual situations where high volatility is guaranteed.

If the assumption was that volatility would fall, the strategy might be to sell volatility by selling options at some distance from the money. Of course, option selling carries much larger risks and so the degree of certainty must be higher.