India’s finance minister Nirmala Sitharaman will be presenting union budget at 11 AM on 1 Feb 2020. Budget announcement is one of the biggest financial events. This leads to a volatility roller coaster in the market and opens up a lot of opportunities for trading. I am going to initiate a trade position that should benefit irrespective of the direction of market on the budget day. Learn options strategy to trade this budget. In Part 1, I will explain in details of the strategy. To avoid any hindsight bias, I am publishing my thought process much before the event. I will later publish a part 2 with the results and analysis of the trade.
Market dynamics on the budget day
Before we can decide on what strategy to be used, we need to understand what happens in the market around such big financial events like union budget.
- Though budget day is a Saturday, the market will remain open as per usual timings. This allows us to take overnight trading positions without risk of gap opening in the market. Had it been a holiday, it would have been too risky to take any non-directional position. Any directional trade is pure gambling as we do not know for sure how the budget will come.
- Due to the fact that no one on the market knows how the budget will come, market can move significantly in any direction after the announcement. Due to this uncertainty (read as fear), implied volatility (IV) will be very high. This means that before the budget, the premium of both call and put options will also be high.
- On budget day, after the announcement, it will be pretty clear where will the market move as all the information will be out. This will reduce uncertainty and will lead to sudden fall in IV. This IV crush will lead to decrease in premium of both call and put options.
- IV crush is not the only thing that will affect the options premium. Based on the budget announced, market can significantly move up or down. If market moves up, call option premium will shoot up. If market moves down, put options premium will shoot up.
Which direction should I bet on ?
The answer is none.
Unless you know exactly the outcome of the budget, do not bet on any direction. Given your directional views will be based on rumors in the market, any directional trade is pure gambling and not trading. In such scenarios, always take a non-directional trade. This can be done by trading both call and put options simultaneously. Some popular strategies are Straddle & Strangle.
Should I sell options ?
As I told, IV will be high before the announcement and it will fall suddenly after the announcement. To profit, I can just sell a call and a put option (also called Short Straddle/Strangle) a day before (On 31 Jan) and exit the position just after the announcement (On 1 Feb). As the volatility falls, option prices for both call and put options will decrease giving profit in both the options. Sounds easy right! We are missing one important factor, the movement in Nifty. Be with me, I will explain in detail.
If Nifty moves up significantly, Call option premium will shoot up. Though we will make definite profits on the Put option, profit on Call option depends on how much Nifty has rallied. If Nifty moves so much that loses are much more than the profit due to IV crush, we can be in huge losses.
If Nifty moves down significantly, Put option premium will shoot up. Though we will make definite profits on the Call option, profit on Put option depends on how much Nifty went down. If Nifty moves so much that loses are much more than the profit due to IV crush, we can be in huge losses.
Since loses of selling options are uncapped, more the Nifty moves, more will be our loses.
So selling option is a strategy backed by hope. We run into risk of huge losses if Nifty moves a lot. We will have to hope that IV crushes and Nifty does not move much.
Should I buy options ?
Budget announcements lead to huge long term financial impact. Thus it is normal for Nifty to significantly move up or down. Why not just buy a call and a put option (also called Long Straddle) and profit from whichever direction Nifty moves in. Sounds easy again, right! Wait there is a catch to this strategy too. I will explain in detail using the following example.
Let say Nifty moves up significantly, call option premium will shoot up. But there is an opposite force which will lead to a decrease in premium of the call option. The force is IV. The IV will fall suddenly leading to decrease in premium prices. Unless profit due to movement in Nifty compensates the losses due to fall in IV, we will make loses from both call and put options. Same will happen if Nifty moves down but not enough to compensate for the fall in IV.
So buying options strategy is also backed by hope. Hope that Nifty moves significantly in any direction and compensates for the fall in IV. If not, both call and put option will make loses.
Option greeks analysis on budget day
[Skip to next section if you do not understand option greeks]
If you have followed me so far, you would be convinced that our strategy should have the following elements:
- Strategy should be non-directional, that is, it should not bet on Nity moving in any one direction.
- Selling options can lead to huge loses. More the Nifty moves, more will be our loses.
- Buying options can lead to loses in both call and put options.
We would need to come up with a custom strategy so that we do not lose our shirt in case of losses and maximise our chances of profit. To understand what is happening on the budget day, we need to understand a little bit about what is happening to the option greeks while selling and buying options.
- Selling a call and a put option is short vega position. Thus it benefits from fall in IV. But at the same time, this position is also short gamma. Thus it makes loss when underlying (Nifty) moves significantly.
- Buying a call and a put option is long vega position. Thus it makes losses from fall in IV. But at the same time, this position is also long gamma.Thus it makes profit when underlying (Nifty) moves significantly.
So we need a strategy which is short vega and long gamma. We can achieve this by combining options with different expiry. Nifty gives us 2 types of options. Weekly options and monthly options. Following are the greeks for these options:
- Vega for weekly option is less than the vega of monthly option of same strike price. So if I buy a weekly option and sell a monthly option of same strike price, I am net short vega.
- Gamma for weekly option is more than the gamma of monthly option of the same strike price. So if I buy a weekly option and sell a monthly option of the same strike price, I am net long gamma.
Got the hint of strategy that we will use ? We will buy weekly Nifty options and sell monthly Nifty options at the same strike price. This will make our position short vega and long gamma. Thus we will benefit from both the fall in IV and movement in Nifty. We will choose ATM options for this purpose.
The above trade is still long theta. So we will be losing time value until we exit the trade. Hence I will enter the trade only 1-2 days before the budget day and exit it after the budget announcement. This enables me to not lose muchin time decay, and still be able to gain on any significant movement in Nifty on days before the budget.
Options Strategy for the Budget day
As explained in previous section, I will initiate the following trade.
- Sell 1 lot of ATM call option of Nifty with expiry on 26 Feb.
- Sell 1 lot of ATM put option of Nifty with expiry on 26 Feb.
- Buy 1 lot of ATM call option of Nifty with expiry on 6 Feb.
- Buy 1 lot of ATM put option of Nifty with expiry on 6 Feb.
Note: Strike price of all the options should be the same and as near the money as possible.
When to Enter ?
I will enter the trade before market close on 30 Jan. The above trade loses on time value, so I would not initiate it much before. It can also be initiated on 31 Jan, but I want to gain on any market movements pre-budget. If you want to gain market movements on 30 Jan, trade can also be initiated before market close on 29 jan, but I would not recommend before that.
When to Exit ?
Exit as IV falls just after the announcement. If IV does not instantaneously fall wait for sometime. Do not worry if Nifty moves, your long options will take care of it. No matter what, exit the position before market close. Fall in IV can be measured from IV percentile (IVP). Also exit if your stop loss gets hit. I usually keep my stop loss at 2% of my capital.
Note: IVP can be tracked by taking paid subscription of Sensibull.
Below is P&L analysis in different scenarios. Analysis assumes the following:
- Nifty is at 12250 when trade is entered. Thus ATM strike price is 12250.
- IV of monthly options falls from ~15 to ~13 after the budget announcement.
- IV of weekly options falls from ~16 to ~14 after the budget announcement.
IV falls and Nifty does not move
IV falls and Nifty rallies ~3%
IV falls and Nifty falls ~3%
When can this strategy lose ?
There is only one scenario where I can think that strategy will lose. Obviously only time will tell if I am right or wrong, but let us go ahead and analyse what I know.
This strategy profits from decrease in IV (short vega) and movement in Nifty (long gamma). It can lose if the exact opposite happens. This means that IV further increases after the budget announcement, and Nifty still does not move much. Though I could be wrong, but this seems anti-intuitive that volatility will not fall once all the budget information is out. More anti-intuitive is, volatility further shot up and the Nifty did not move at all. But hey! Market can always surprise you. So prepare to take losses if this happens. Always have a predetermined stop loss. I usually keep it as 2% of my capital.
Note: As we will be holding an overnight position, I am assuming that the world market would not crash while I am sleeping with this position on. If that happens, this strategy can make loses.
Learnings from readers
Some readers pointed out another scenario where this strategy can make loss. I will explain it here.
IV of monthly and weekly option may behave differently. Since both are pretty high before the budget, both will usually decrease. It may happen that IV of weekly option decreases much more than IV of monthly option. As we are long on weekly option and short on monthly option, such IV crush will hurt the position. Only savior here will be our gamma. So if Nifty moves significantly, it will compensate the losses. But if Nifty also does not move much, the strategy can lose.
Thanks to all the readers for being so smart and analyzing the strategy is such detail.
Read about what market conditions are suitable to initiate a Long or Short Straddle.
Disclaimer: Options involve substantial risk and are not suitable for all investors. Options investors may lose the entire amount of their investment in a relatively short period of time. It is possible to owe more than you have invested in your brokerage account. Please be aware of your broker’s requirements for trading options. Before you decide to invest in the options market you should carefully consider your investment objectives, level of experience, and risk appetite. The possibility exists that you could sustain a substantial loss which could total more than your initial investment in a short period of time. Therefore you should not invest money that you cannot afford to lose. If you have any questions or concerns regarding the risks associated with option trading, you should confer with a trusted and reliable independent financial advisor. None of the information provided in this blog constitutes a solicitation to trade any investment or security of any kind.