Last Updated : Nov 25, 2018 09:51 AM IST | Source: Moneycontrol.com
Here’s how to trade before, during and after the state elections
The call one has to take here is not whether or not uncertainty or better put volatility will make its debut but the trade here is on the magnitude of that volatility
Options are best suited to handle risks associated with uncertainty. There could be no better time to employ this wonderful instrument than when you already know the event behind the uncertainty.
Today, let us discuss how to best deploy options during and around a known event. But before that, let us understand the subject matter of discussion is a known event so one has to remember that the current premiums would be pricing the expected volatility.
The call one has to take here is not whether or not uncertainty or better put volatility will make its debut but the trade here is on the magnitude of that volatility.
Now, let us break it down into three parts:
Before the event:
The trade here is predicated on the fact that option premiums are not pricing event volatility, which it should. The research-backed expectation has to be built here.
Cues can be taken from various factors like the current state of affairs, empirical evidence volatility priced into options of such events. Any option premium calculator would help you find the expected volatility a.k.a. implied volatility (provided the rest of the factors and the volatility figure that is required to arrive at a market premium).
Let us just say that the event falls within a few market sessions and one finds that there is at least a 10 percent difference between current and expected implied volatility before the event. Just go ahead and buy the option. Square it off just before the event.
If your call was right, there would be a fair amount of gains, else the natural course of upward-looking implied volatility term structure would at least make sure that the money at stake in the trade is minimal. This makes it the most scalable of the three trades.
During the event:
Since we are talking about a particular event, we need to pull out this factor as well. Here we need to build a research-backed expectation of the implication of the event.
A simple calculation of adding both Call and Put premiums of strikes close to the price, one would know how much movement from current prices is expected.
If the expectation is of reasonably (30+ percent) more than that simply buy the volatility by going long on both Call and Put. However, if it is other way around, go short on both.
But in case of shorting make sure it is a little far off strike. But we do buy a higher Call and lower Put for ‘just in case’ situations.
This is a time bound bet but the P&L could be highly impacted, hence I have been practising a rather smaller position size.
After the event:
Once the event is over the implied volatility is expected to come down unless there is an impending piece of information.
Review the implied volatility figure, if it is anything more than 5-7 percent higher than the normal figures and the event is over, go short on volatility.
Sell out of the money Call (higher) and Put (lower) strictly for intraday, as if its an anomaly it has to correct within minutes.
Expect a small gain in minutes. Not necessary but since it is an event, once again I practice using the premium received to buy too far off Call (higher) and Put (lower).
Hold it for an hour or so and exit before the session ends. Once again the P&L may not be enormous but it’s a natural process so if spotted anomaly at the right time in right event setup, odds of making money are favourable.
Thus, when it is event one can seek opportunities in perceived and realized volatility with the use of options.
The author is CEO & Head of Research at Quantsapp Private Limited.