How Option Traders Beat Budget Uncertainty
There's usually uncertainty in the market in the run-up to a budget. More so this year as Narendra Modi government was expected to announce welfare measures in its last budget ahead of the general election.
Risk-averse traders use options to trade in the direction of the underlying trend. One strategy that has paid off in the past is to buy at-the-money straddle of Nifty index option close to the end of the budget day with more than 20 days to expiry.
The straddle involves simultaneously buying a call and put option with strike price identical to the market price of the Nifty Index for the same expiration date.
- A call contract gives the holder the option, but not the obligation, to buy a security at a pre-determined level or price.
- A put contract gives the holder the option, but not the obligation, to sell a security at a pre-determined level of price.
- At-the-money option contracts have strike price identical to the market price of the underlying asset.
The average return of this strategy was about 1 percent per trade for the last 11 years with maximum gain and loss of 6.21 percent and 3.82 percent, respectively.
This position has a limited risk as the buyer can lose only the cost incurred in buying these options. But it gives an unlimited upside if the index moves significantly away from the strike price in either direction.
The strategy has a positive expectancy of more than 63 percent since 2008. The February 2019 expiration at-the-money straddle is currently quoting at about 3 percent of the underlying price.