Shubham Agarwal outlines three trading prohibitions for F&O ahead of election results
For Option Traders, volatility or expected volatility is equally important, we need to account for movement in that as well especially ahead of event.
Shubham Agarwal
Once again, we have a known event around the corner. Results of multiple state elections are upon us with little over a week’s time. This event is special because with elections unlike other events like union budget or monetary policy we have relatively bigger speculations.
As a result, we always run a risk of big spikes in volatility and unpredictable drops or rise in the underlying. Either way it becomes highly likely that if we are not prepared for it, we could lose a lot of money in very short time.
Since for Option Traders volatility or expected volatility is equally important, we need to account for movement in that as well especially ahead of event. With such an increment of interest in Option Selling, we need to remember that sudden spike in expected volatility (represented by India VIX here) will definitely hurt the trading P&L very hard.
The grey circles point it spike in expected volatility indicated by spike in India VIX (big hit on P&L for Option Writers). The blue circles indicate the dual effect, a drop in prices of Nifty as well as rise in expected volatility (after effect). Both affect F&O traders as sudden unpredictable directional move + spike in expected volatility do create possibility of a big loss.
However, few DO NOTs especially for these times (ahead of the event), could save us from any such shocks.
DO NOT Trade Only Futures:
No matter whatever direction we choose to trade, we all understand that we invest a part of the entire contract value to Buy or Sell Futures (~25 percent of total value of contract as margin). What I mean here is that given a violent move there is a chance to lose even more than what we have invested.
The solution lies in converting Future Buy or Sell into Protected Future Buy or Protected Future Sell.
Protected Buy = Buy Future + Buy Put (Option to Sell) Option with Strike close to current price.
Protected Sell = Sell Future + Buy Call (Option to Buy) Option with Strike close to current price.
This will essentially stop the losses if there is big move against us. Sure, it will increase the cost of the trade (Option buying cost + profit reduces by cost of option) but better safe at a cost than sorry.
DO NOT Ignore Possibility of Zero:
Option buyers could be required to pay a little extra premium due to expected volatility. This modification is more of a behavioural and position sizing one.
Whenever we Buy Options be ready to bear the loss if entire premium turns to zero.
DO NOT only Sell Options:
Do not have net Sell options positions. For every Sell Option (Call/Put) add a Buy Option (Higher Strike Call/ Lower Strike Put).
This is similar to Protected Futures, but it will make sure that we are not unduly risking a lot of capital for a small premium by selling Options.
Now, even if we are wrong and caught with a negative surprise we would still have limited and known loss and will not run out of business.
First published on 25 Nov 2023: prices, lot sizes and expiries are those of that time. They are illustrations for education only, not investment advice. Derivatives trading carries risk; read all scheme and risk documents before trading.
