The Right Time to Trade Volatility

Asad Dossani

Last week, I discussed how easy it is to trade volatility using options. The easiest method is an option strategy called a straddle. If you think vol will go up, you buy a call and put option with the same strike price. If you think vol will go down, you sell a call and put option with the same strike price. The strike price should be close to the current index value.

When should we buy vol? And when should we sell it? Our goal is to predict whether implied vol will be higher or lower than realised vol. Implied vol comes from option prices, while realised vol comes from the underlying asset. If implied vol is higher than realised vol, we should sell. If implied vol is lower than realised vol, we should buy.

We can observe implied vol at the time of making a trade. For example, the India VIX tells us the implied vol of the Nifty Index. The realised vol is known only after the trade is made. This determines whether the trade will be profitable or not.

While we don't know future realised vol, we can observe recent historical vol. Usually, this is a good predictor of future realised vol. The NSE website has a tool to compare current implied and historical vol of the Nifty Index. Here is an example of these values as of 30 August.

 

In the first column, we observe that historical vol is 11.79% in the last ten days. Meanwhile, in the last column, average implied vol is 15.34%. This is a fairly large gap between the two. This means it may be a good time to sell vol.

Of course, the actual profits depend on future realised vol, not historical vol. If future realised vol ends up around the same levels as recent historical vol, then selling vol is profitable. If you look at historical vol over the last three weeks, it has remained low, but slowly trended upwards. However, implied vol has moved up even faster.

One caveat is that we need to be aware of any upcoming news event. Sometimes, implied vol could be a lot higher than historical vol. And that could occur if there was a large news event coming up (e.g. RBI interest rate announcement). In this case, future realised vol is likely to be higher than historical vol. And we should probably rethink our trade. You can learn more about trading vol in our latest e-learning course Derivantage.

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Market Notes

Is the Rollover Data Indicating a Resumption of the Uptrend?

It was a thrilling expiry for the Indian stock markets. The Nifty 50 Index experienced decent selling during the August expiry after a long time. Although the index recovered a bit, bears had the upper hand in the August series, which is what our previous rollover report suggested.

In our July expiry rollover report, we saw lower-than-average rolls and open interest (OI), which was at a six-month low, declining in absolute terms. This meant that bulls gradually exited their positions, suggesting a strong correction to the Nifty Index. And the Index did correct to the 9,685 level - down from 10,020.

So will the bears continue to dominate in the September series as well? Let's see what the rollover data suggest this expiry.

But first, what is rollover?

Rollover refers to traders shifting their future contract positions from the near-month contract to the next-month contract. For example, Nifty traders are shifting their future contract positions from the August expiry to the September expiry. Here's the formula:

Rollover % = Next Month OI (M2)
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Near Month (M1) + Next Month OI (M2)

The rollover formula tells the percentage of contacts rolling into the September expiry from the total contracts outstanding from the August and September expiry.

This month, Nifty rollovers stood at 57%, which is lower than the previous three-month average of 71%. Open interest (OI) was 1.64 crore contracts compared to 1.72 crore in the previous expiry. Open interest in absolute terms decreased and the rolls were also on the lower side. In fact, the rollover is the lowest in the last one year. This suggests traders are reluctant to carry forward their positions into the next series.

The Nifty lost 1% for the expiry with absolute open interest decreasing and lower than average rollovers. This indicates most of the short positions in the index that were built up in the August expiry did not roll into the September series.

This might come as a relief to the bulls. But since OI is at its lowest level, we need strong confirmation from other data and price action. Let's have a look at what the other data have to say.

Nifty Options Matrix (Open Interest)

On the options front, the Nifty put-call ratio (PCR) stood at 1.33. This means put open interest is higher than call open interest. Being a contrarian indicator, a high PCR reading is generally favourable for the markets.

The 10,000 strike call has the highest built-up with 28.60 lakh OI. And the 9,700 strike put has highest built-up with 38.03 lakh OI. Based on this, 10,000 can act as resistance and 9,700 as support in the September expiry. As seen in the chart above, the 9,800 put too has strong OI outstanding.

Thus, looking at the option matrix, the 9,700-9,800 levels is offering strong support. This suggests it might be difficult for the bears to push the index below these levels. Also, call writing seems weak compared to the put writing, indicating the bulls' dominance.

Now let's look at the Nifty chart.

The index traded on a weak note during the expiry. It witnessed buying during the first week of the expiry to hit a life high of 10,137. But the buying was temporary as the index slipped sharply during mid-expiry. The index then recovered some of its losses and traded in a range of 9,750-9,900 for the rest of the expiry. Finally, it ended the expiry with a cut of 1%.

The index is currently trading near its channel support line and is constantly finding support from its 50-day exponential moving average (EMA) at 9,800. Also, the 9,700 level, which acted as a strong resistance on the way up, is now acting as a strong support for the index. But the 9,900-9,950 area is also acting as a minor hurdle. So if it is able to trade above this level, it will open up higher levels for the index.

Nifty 50 Index Ends August Expiry 1% Down
Nifty 50 Index Ends August Expiry 1% Down 

So the bears dominated the August expiry, but the rolls were on the lower side (at one-year lows) and the absolute OI was also low. This could mean the bearish positions built up in the August expiry did not carry forward in the September series.

Apart from this, 9,700-9,800 level has a strong cluster of support. The index has maximum put writing at these levels. The 50-day EMA is also placed at the 9,800 level, which acted as a good support since June. And the horizontal support level is also placed at the 9,700 level.

So it will be quite difficult for the bears to push the index below the 9,700-9,800 levels. But if they can, the index might well continue to correct. Until then, the weight of evidence favours the bulls.

From The Market Wizards...

'It can be very expensive to try to convince the markets you are right.' - Ed Seykota

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1 Responses to "The Right Time to Trade Volatility"
Ratneshwar Prasad
01 Sep, 2017
Very informative in simple language.Look forward for such articles.Like 
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