Selling Volatility A Good Bet!

Selling Volatility A Good Bet!

The market is currently new about it. However, there are periods when the volatility suddenly jumps abnormally and over a certain time it normalises. In such uncertain times when volatility is dominant it makes sense to ‘sell volatility’. Shreya Chaware explains what this term means and also highlights the risks involved 

 It is a penchant of sorts for investors and traders to take a directional call on the market. No matter how many experts emphasise and explain the futility of taking directional calls to consistently make money in the long term, there is a huge population of investors and traders willing to bet on directional call on the market on a regular basis. The lure of making big gains in the shortest possible period is the reason behind such decisions. However, it is generally accepted that getting market directional calls consistently right is not only hard but extremely rare.

On the other hand, it is the strategy of selling volatility or writing options that has proven to provide consistent returns, even though the size of gains is substantially reduced. Look deeper into the statistics or performance of options traders and it is not difficult to realise that if one were to consistently position for market swings using non-directional option strategies, the chances of success i.e. positive returns improve drastically. What are non-directional option strategies? These strategies are nothing but option selling strategies and are also known as ‘short volatility’ strategies.

Short Volatility Strategy

Short volatility strategies in option trading generate returns by earning a premium i.e. an upfront premium in return for selling options. Option writers assume unlimited risks for small but consistent gain. Usually, institutional investors, high net-worth individuals and investors with deep market insights indulge in option selling activity. Often, small investors and traders find it easy to take directional bets using options trading instruments because the potential for higher returns is limitless and the risk is limited to the option premium paid. Investors find it is attractive to bet on something where the losses are predefined and the gain potential is unlimited. 

Says Hitesh Oberoi who has just started trading in derivatives instruments: “I have made good money buying stock options and index options. The percentage returns are unbelievable. However, I am now realising that the strike rate of my win percentage is slowly coming down and I am afraid if it continues like this I may end up eroding my capital. So far, my portfolio is in green and my directional bets have paid off, but I am not sure if I can continue the outstanding performance. My scepticism is on account of the low strike rate off late.” 

Interpreting VIX for Profitable Trading

Volatility measures the frequency and magnitude of price movements that a financial instrument experi- ences over a certain period of time. VIX is a real-time volatility index which reflects the volatility expectation of the market participants over the next 30 calendar days. It is often referred to as the ‘fear gauge’ and is used by investors and traders to ascertain the market moods before taking invest- ment or trading decisions. India VIX is computed by using the best bid and ‘ask’ quotes of the out of the money, present and near-month Nifty 50 option contracts. Higher the India VIX, higher the expected volatility and vice-versa.

Suppose Nifty 50 is trading at 17,000 and VIX is currently at 25. It can be interpreted as a probable annual variation of 25 per cent in the next 30 days. It is critical to remember that the variation is annualised and the monthly variation comes close to 2 per cent. This essentially means that Nifty can move in either direction by ~350 points. The reason why VIX is paramount for investors and traders alike is that it is a good measure of expected volatility and indicates whether the market participants are feeling complacent or fearful about the near future. There is a negative correlation between India VIX and Nifty 50.

VIX tends to drop when Nifty goes up, and vice-versa. Investors who are worried about markets going down can hedge their equity portfolio by buying India VIX futures. Inves- tors can also short the India VIX futures in case they believe that India VIX has peaked. One of the best ways of profiting from India VIX futures is by going long at lower levels ahead of a major event that promises to make markets volatile. As an investor or trader, market sentiment indicators can be your trusted companion in the journey of wealth creation only if you know how to read and interpret them correctly. The stratagem to outperform markets is to understand VIX reading accurately and then adjust your trades and positions accordingly.

Time Decay : Time decay is a measure of the rate of decline in the value of an options contract due to the passage of time.Time decay accelerates as an option’s time to expiration draws closer since there is less time to realise a profit from the trade.

Indeed, a lot of investors are attracted to option trading when stories of ‘big profits’ in a single trade make a permanent impression. At such times, investors make the cardinal mistake of not noticing the extremely low strike rate of such ‘big profits’ and always focus and remind themselves of occasional huge profitable trades before indulging in options trading. If an option trader is looking to book consistent profits and not just a one-off huge profit, selling options should be the most preferred strategy. Investors at times get confused whether buying options or selling options is a more rewarding experience.

The truth is that trading including options trading is a zero-sum game in the sense that the money made by the seller of the options is the loss booked by the buyer of the options and vice-versa. If it were the case that the buyers of the options always made more money than the sellers of the options then in that case, rationally speaking, there won’t be any trader willing to sell options as there is more money to be made in buying the options. It all boils down to the preference of the risk-reward relationship by traders. Options sellers can expect to make several consistent small gains while options buyers need to ready to book several losses and hope to more than recover all the losses in just a few trades.

As Rajeev Bhosale, who has been writing options for the past few years, puts it, “I prefer writing options over buying options simply because the probability of winning increases manifold. Yes, the winning amount is small but more consistent. The trick is to avoid writing options ahead of major events such as elections, RBI announcements as regards interest rates, IIP or GDP data announcements, major government policy decisions such as the budget, etc. There is always a chance of making heavy losses when stock prices move in a particular direction in quick fashion which does not allow the option writer to adjust or hedge.”

“If you can avoid participating in such times when the market trades in a single direction, there is very good probability of winning in the market consistently – albeit you have to be content with small gains in each trade. I prefer writing options also because it provides flexibility as I can at any time buy back my options and shift the contract levels as per the market conditions. One of the most important benefits of writing options is to gain from time decay. The concept of time decay, even though easy to understand, is practically not exploited by most options traders,” he adds. “

Time decay is the most useful feature of options trading that gives options writer an advantage. Time decay is where options traders like me make consistent money. The best gains are accrued when the option expires worthless. Even though the premium is received immediately, the risk, at least in theory, is unlimited. When volatility is at its peak and the best estimate is that the volatility is expected to subside, writing options is even more profitable. Another way of trading profitably when volatility is high is to short VIX futures,” he further states.

Conclusion
Selling volatility as a strategy is most appropriate and profitable when the volatility is extremely high. Volatility is measured by VIX. Unprecedented events such as the current geopolitical situation between Russia and Ukraine induce huge amount of uncertainty in the financial markets. For instance, we have seen some abnormal spikes in crude oil prices and in the metal prices. The supply chain disruptions caused due to the war have fuelled the volatility further while also ensuring that the prices of raw materials jump higher. With so many uncertainties impacting the markets right now, the premium for the options is seen rising.

And hence as volatility is at its peak, it makes sense to sell volatility as it is trading higher. Tracking VIX can provide good indications as to when the volatility may subside and when it can be expected to rise. The 52-week range for the Indian VIX is 9.025 to 33.997. As the Indian VIX trades closer to its higher end of the range one can start contemplating using selling volatility strategies with a view that volatility will eventually subside. During the pandemic breakout the Indian VIX traded at ~65 levels. Similar levels for VIX were seen during the global financial crisis in 2008. This goes to show that the heightened volatility may remain longer than expected and that it is almost impossible to predict the peak when a contingent event occurs.However, volatility tends to subside over a period of time no matter how big the issue that is impacting the markets.

Critical situation analysis is required for traders and investors to indulge in selling volatility strategy whenever there is a contingent event impacting the markets. During volatile times the premium no doubt increases but the strong movement of stock prices in any direction can make option writers book heavy losses. Owing to the current geopolitical situation we expect volatility to remain high in the near time. Option writers do have a chance to earn higher premium which in essence is 

the reward for taking higher risks. It all likelihood, volatility is here to stay a little longer than expected as the current geopolitical issue refuses to die down even as the crude oil prices rise and keep disturbing the market’s chances of steady recovery.

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