Optimal application of options in low Implied Volatility times

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Since the pandemic hit us few months back, we are trading with the lowest level of Implied Volatility (IV) at least for Nifty.

Implied Volatility which is nothing but a back calculation of volatility priced into option given the premium at which it is trading can be looked at as standard valuation of options.

This number lets us know the expensiveness of the option premiums. Lower the Premiums lower would be the IVs. While this could get sensed but not objectified that, are we in an expensive option premium regime or inexpensive one?

With Nifty IVs collapsing to sub 30 percent after hitting the high of over 100 percent around a couple of months back, we are definitely trading with inexpensive options. Best use of these times can be done via shifting to the Low IV regime trading.

We will discuss few trades that could come handy for such times along with their benefits to help better application of them.

#1 Directional Trading with Single Options:

The Biggest hindrance for a Buyer of an option is the time value and the perishable nature of the option as an instrument. While the perishable nature remains inherent feature of options, time value is something that gets favorably affected by Low IV regime.

Lower IV means lower premiums paid for buying same option that with other things being equal can immediately increase the ROI by two different impacts.

1. If the actual price action is favorable there would be gains on the option premium

2. Remember that IV is mean reverting in nature for some reasons it starts to rise from the extreme lows, there would be gain in option premiums despite no price action

#2 Protective Put against Covered Call:

More or less on the similar lines of trade #1 when options are being associated with futures for achieving a hybrid pay-off that outperforms the standalone future, here choose protective Put (Buy Future + Sell Put) over Covered Call (Buy Future + Sell Call).

Most situations when the IV hits low more often than not the market would be at intermediate highs. On top of that buying inexpensive options is always a better choice than selling ones. The benefits remain similar to that of #1 plus this trade at relatively lower cost would mitigate the risk of drawdowns and convert this futures trade into a known loss strategy, which is a prudent step when the market has gone through a decent rise.

#3 Balance the Ratios:

With incremental attraction to weekly options, a lot of option traders resort to option trading strategies with net options sold. Ratio strategies are one of the favourites among them. Here one buys a Call or Put and Sells multiple Higher Calls or Lower Puts. While this is valid in normal times but when the IVs are incredibly low, it becomes difficult to create expected yield in ratios with distant strikes.

Generally, one would try and create sell positions in relatively closer strikes. This does help in keeping the net premium outflow in control but creates incremental risk. Also, a possible reversal in IVs is a greater risk loom always on such trades.

Best way to handle this is, keep doing whatever we are doing but with just a minor alteration. Add Buy Call on even higher strike or for Puts a Buy a deeper strike beyond the sold strike. This would help balance the ratio. The risk of increment in IV as well as increment in volatility in our favourable direction are both taken care off.

Different regimes of IV gives different opportunities, hence optimizing on those with different option trading approaches is always profitable than having one standard approach.

(The author is CEO & Head of Research at Quantsapp Private Limited.)

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