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CM Strategy

Optionalysis: Writing Options Fraught With IV Rise Danger, But Risk/Reward Favourable

Optionalysis: Writing Options Fraught With IV Rise Danger, But Risk/Reward Favourable

This is a post for Capital Mind Premium subscribers, sent on 02 May 2014.

You might think the Vix is high, at 33. Or that implied volatilities look very high. And that the index is likely to be seriously volatile after the 16th, when the election results are announced. But is there a play till then?

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Options are extremely short term plays as well as long term strategies. In the short term – for say a week or so – does it make sense to sell options? (Straddles or Strangles)

The Nifty 6700-6800 strangle is at Rs. 437. Let’s assume we go short that straddle today (Friday). With implied volatilities the way they are, what is the situation today? (Assume a position of 500 Nifty each)

Optionalysis: Writing Options Fraught With IV Rise Danger, But Risk/Reward Favourable

But, assume that we wrote this strangle today, and we waited till Wednesday (7 May). If the implied volatility was the same (around 33% averaged) we will see the graph change this way.

Optionalysis: Writing Options Fraught With IV Rise Danger, But Risk/Reward Favourable

The same position profits about 23K over five days, if Implied volatility is the same. The exposure is about Rs. 10 lakh (at Rs. 1 lakh per contract, 10 contracts).

And, the range of profitability is between 6480 and 6980, a fairly wide range.

What if Implied Volatility goes up?

For the position to see losses IVs need bump up to 37% average.

Optionalysis: Writing Options Fraught With IV Rise Danger, But Risk/Reward Favourable

And this is the bet – would you think implied volatilities remain the same?

A bump up from 33% to 37% isn’t that much – after all, we’ve seen average volatilities go from below 20 to above 30 in a month!

The VIX is up 6% today already. And it’s likely to go to 40%+ by the 16th. It’s a big risk to make assumptions on implied volatility.

But the risk/reward is favourable for writing options – the losses made on a sharp VIX rise are lesser than the gains made if IV remains the same (or falls). In the above example, a 4% increase in IV in four days results in a Rs. 8,000 loss, but the same IV in 4 days is a Rs. 23,000 profit, on an exposure of Rs. 10 lakh.

We would bet on the side of writing options but with 50% of the quantity we would normally bet. This is our strategy over the next week. Note that this is fraught with serious risk!

Note: How did we get those graphs? We used Options Oracle, added positions to the chart, and use the “Graph” option. You can then cycle between now and the expiry date to find out how your option position will move, and change Implied Volatility too.

Optionalysis: Writing Options Fraught With IV Rise Danger, But Risk/Reward Favourable

Disclaimer

Nothing in this newsletter is financial advice and should not be construed as such. Please do not take trading decisions based solely on the matter above; if you do, it is entirely at your own risk without any liability to Capital Mind. This is educational or informational matter only, and is provided as an opinion.

Disclosure: The authors at Capital Mind have positions in the market and some of them may support or contradict the material given above, or may involve a direction derived from independent analysis.

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