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Charts & Analysis

System Trading – Time for a Nifty straddle?

A small system update: We’ve been testing and working with about 3 systems with real money and a couple others under a test phase. We’ve thrown out two – one gave us a bad drawdown but we’ve modified and are paper trading that, and the other is not implementable because of lack of proper infrastructure.

The third- and our flagship – is now at around 16% real money return over three months. We tried some stunts – leveraging it, adding/deleting capital etc. – just to see how it performs. But now we’re back with a non leveraged system – and 16% is the auditable profit.

Interesting some other systems come into play once in a while – not every day, or every week – but just once in a while. Kinda like Kaushik’s Gold/Nifty pair trade (29% in three weeks there).

One such thing I’m thinking of is a Nifty option straddle or strangle. The Nifty was at 4300 on June expiry, and at about the same level in the July expiry. In August it closed at 4210.

This is a fairly tight range, and I looked back a little bit to see how such a scenario has panned out. Nifty has had futures only since 2000, but real trading probably started in 2002. SO let’s check a 1 month (expiry to expiry) move and a 2 month move since 2002:

  • Every time both one month and two month moves have been less than 4%, there has been a 10% move (expiry to expiry) in the subsequent two months (either one month or two month).
  • Except once, in Sep/Oct 2002 where such a situation lasted two months (i.e. one and two month moves were less than 4%) and the third month there was a 10% move. Even then I’m not sure I should bother because the nifty future turnover on expiry day was 100 cr. We do that
  • There may be large fluctuations within the month but I’m not counting those.
  • Our current one and two month moves – as of end August – are 2% each.

Would it be conducive to buy a straddle (buy a put and call at the expiry strike)? Or a strangle – an out of the money put and an out of the money call?

I can’t really back test – because I have only a few data points and options only got really liquid only after 2005 or so. But it seems like there is a profitable opportunity if one were to buy a straddle for around 5% when such situations occurred.

Current straddle rates are around 8% (300 points on a Nifty of 4200). Not entirely profitable, to be honest – but if the Nifty stays in this range till mid-month, things might be better. Need to do a comprehensive back test, but it’s fodder to start.

Now other situations exist. There could be the situation that an intermediate move will take you into a profit zone. Also need to test strangles. Finally of course, implied volatility plays a part – so perhaps the idea is to buy low IV strangles, as compared to the rest of the option chain.

This is more of a low frequency, high probability (LFHP) trade. It won’t set up every day or every month, but when it does set up it has a high chance of success. Now if we were to get 50 such LFHPs, maybe we can get a more stable return. (Of course, with Murphy’s law, all will set up at the same time, and you will not be able to allocate capital). Still, if the returns are reasonable on a per-setup basis, this might be a way to get alpha in the longer term.

Disclosure: Long a Nifty strangle [Couldn’t resist]

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