Punting on election results

Election results are due on May 23, which is also weekly settlement day for Nifty and Nifty Bank options, with the previous settlement on May 16. This period is likely to see extreme volatility, which will continue until May 30 settlement at the least.

Option traders will get a chance to make (or lose) a quick buck. Here are a few thoughts. The market has started falling, mostly due to Donald Trump’s derailing of US-China trade talks. But there is also nervousness with some BJP top-brass signalling that the National Democratic Alliance (NDA) isn’t likely to win a majority, since it is exploring post-poll alliances.

The swings would get wilder after May 20, when exit polls are released and rumour mills go into top gear. Option traders can take a view on likely political outcomes and short-term impacts. If the Bharatiya Janata Party (BJP) does win a majority, the market response will be very positive. In this case, the May 23-30 period will see a sharp climb.

If there is a coalition, any coalition, there will be days of uncertainty and horse-trading. That period will see violent index swings based on rumours. If the BJP puts together a coalition, there will be initial panic, followed by a positive move, if Narendra Modi retains the PM-ship. If the BJP cannot stitch a government together, or if it puts together a government without Modi, there will be some panic and the market response may not be so positive.  

In technical terms, the smart money is set for big moves. Option premiums are very high and the volatility index (Vix) has spiked to multi-year highs. It would be very risky to be a naked option-seller. Given a wrong view, losses would be very high.

Consider a concrete situation: The Nifty could gain or lose over 5 per cent in the next fortnight. It is seeing daily high-low moves of over 1 per cent. A move of around 550-600 points in either direction from the current levels is possible, or even likely, if you note the Vix.

One way to cover both possibilities, is to take wide strangles. A combination of May 30, long puts and long calls with strikes far from money could be profitable. The trader could seek strikes that are about 200-250 points away from the spot Nifty. Such positions could be offset by short options even further from money. A wider short strangle coupled to a long strangle would reduce costs, but also reduce potential profits.

This is a two-way position. It gains if there is any big breakout or breakdown. If the trader is willing to take a view and accept bigger risks, it’s possible to skew a basic strangle to make a bigger payoff in unidirectional moves.

For example, let’s say a trader believes a crash is more likely. Then, she can take two long puts versus one long call. Or, she can take a long put that’s closer to money (Say 200 points away) and a cheaper long call that’s further away (say 400 points away) as a hedge. The mirror positions could be taken if the trader feels the market is likely to shoot up.

One further point. The Bank Nifty has enough option liquidity and a very high correlation to the Nifty along with higher beta. That means the bank index swings more than the Nifty, while going in the same direction. A trader could take similar positions there but the higher amplitude means she must use a 3x multiplier. Take strangles 600-700 points away.  

This is a short-term situation where traders could make big profits or big losses. The longer-term trend is likely to be negative, regardless of the shape of the next government. There’s a lot of bad news at the moment. At the macro-economic level, the Fiscal Deficit has ballooned, turning Budget estimates into nonsense. The full-year and Q4 results indicate no demand recovery. The global environment is poor. The next government is committed to populism, whatever its composition.

A deep correction lasting several months or longer, is very likely. That presents a different kind of opportunity, with different types of risk. If there’s a crash, the passive investor must be prepared to average down, increasing quantum of systematic investment plans as the market falls. That way, they will be better placed for the next recovery whenever that comes.

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