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Portfolio Strategy: Use Options before taking a bet on Gujarat election outcome

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Events usually attract attention for the bulk of investors and traders with intentions to a) Hedge a likely risk b) Generate returns from a directional forecast on outcome c) Make money from a forecast on volatility.

Events usually attract attention for the bulk of investors and traders with intentions to a) Hedge a likely risk b) Generate returns from a directional forecast on outcome c) Make money from a forecast on volatility.

Let’s learn quickly about all three.

Hedge a likely risk:

If you are an investor, protecting your portfolio from a damage is of utmost priority. What if there exists a strategy to save the losses and keep the upside potential open?

That’s where Option helps.

Assuming a portfolio of 10,00,000 on which you would like to create a hedge. Now, trading Options for each stock you hold could be quite expensive – so you need to calculate the sensitivity of your portfolio to a benchmark Index like Nifty.

Let’s say the Beta of your portfolio is 1.5, this means that if Nifty moves by 5 percent your portfolio can move by 7.5 percent (5 percent * 1.5). So, here is how to create the required quantity for a hedge using Put Options.

((Portfolio Value * Beta) / (Strike * Lot Size)) * Hedge Ratio (Normally between 1-2)

((1000000 * 1.5) / (10300 * 75)) * 1.5 = 3 Lots

If the Nifty falls post-event by 5 percent then you still make 0.75 percent return and in the case of a 5 percent rise, your portfolio gains 5.4 percent.

If nothing happens you lose 0.5 percent from the time value decay of the Put. The additional risk of Volatility movement also remains but should not be significant in this case.

(* Calculations are done assuming prevailing prices of Nifty, 10300 Put, Constant Volatility, December 19 as exit date and Black Scholes Pricing Model.)

Trading for a Directional Expectation:

If you already have an expectation of the movement post the outcome, the simplest way to trade would be Futures but buying options can help limit the downside with an unlimited upside potential with a cost of Theta decay or any volatility drops.

Trade Volatility (Uncertainty):

Yes, you are reading it right, uncertainty can be traded and can yield returns too. A forecast that Nifty may move either 3 percent up or 3 percent down post-event is also a valid one to create an options strategy.

Let’s take the barometer of Volatility as India VIX, if you believe that market is underpricing the event risk and the outcome could be a higher volatility this can be traded using strategies like Long Straddle (buying same strike call & put) or by a Long Strangle (buying OTM call & put).

If you expect a lesser volatility than the market then you can take a reverse trade namely Short Straddle or Short Strangle.

A payoff example for Short Straddle:

India VIX down from 15 to 12 with 10350 Call & Put Short on December 19 can yield a return of anywhere between 10 percent-12 percent(on Span margin, 6 percent-7 percent with an additional exposure margin of 3 percent) with a 3 percent move on Nifty.

(* Calculation done using prevailing prices of 10350 CE & PE with 3 percent decline in IV and December 19 as the date of evaluation. Black Scholes Pricing Model is assumed)

Author: Subham Agarwal is CEO & Head of Research at Quantsapp Private Limited

Source: https://www.moneycontrol.com/news/business/portfolio-strategy-use-options-before-taking-a-bet-on-gujarat-election-outcome-2462809.html

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