The state assembly elections were a big eye opener for the incumbent party. The results were a big surprise across the board. This sets up the 2019 Lok Sabha Elections to be a cracker.
Elections are one of those events that bring in the highest levels of uncertainty in the financial markets, and with good reason. Political stability of the lack of it, is a critical factor for the stability of the markets. Results of general elections have also resulted in massive spikes in the market levels as seen with two upper circuits hit in 2009.
How does a trader attempt to trade against others trying to hedge their portfolio risks?
As portfolio managers attempt to protect their long only portfolios, they look to buy put options to hedge downside risk. Some traders look to tag along these hedges and buy put options even without the long only portfolios. Some others might look to buy put options with a view of playing downside directional movements.
All of these actions tend to lead to an increase in the Implied Volatility of these put options.
The dates of the 2019 Lok Sabha elections have yet to be announced but most estimates peg it around the April-May months. This makes the Jun 2019 options a prime candidate for those trading this event.
So let’s look at some analysis of the prices these options were traded at. These trades occured on 17-Dec-2018 in the 9000 and 10500 strikes. A spike in the Open Interest shows up in the afternoon session of the 17th.
Some quick options analysis shows that the 10500PE was traded at an Implied Volatility of 21 and the 9000PE at an IV of 23. This seems a reasonable IV smile, although I’d have expected the 9000PE to be priced higher.
The charts show the put spread was traded at a net price between 300-310. For a 1500 point spread that represents a net at risk ratio of 0.2 (300/1500). Using implied futures for Jun 2019, the net delta of this long Put Spread is about -0.23. This implies that the trader was able to buy these cheaper than the net delta of the spread. A bulk order of this type probably allowed them to get this deal.
Such a trade isn’t really put on for a short term expiration but the payoff shows the negative delta nature of the trade. This only gets stronger as the Jun 2019 expiration approaches.
Such a trade has minimal theta decay and the key cost is the cost of margin deployed to sell the 9000PE.
What does the trader expect?
During the lifecycle of the trade, the trader expects one of the following scenarios to unfold.
- Rise in Implied Volatility into the 2019 Elections event
- Fall in Nifty levels into the event
In either of these scenarios she stands to profit with this delta negative, vega positive bearish put spread.
What does she have to lose?
A rise in volatility might not materialize, although unlikely. Also the Nifty might actually rally up beyond the long strikes and all strikes might expire out of the money and worthlesss.
As of 17-Dec-2018, when this trade was put on, the long strike at 10500PE was trading OTM with a delta of -0.31. With a rise in the Nifty this option continues to move further OTM.
Would I put this type of trade on?
Most certainly. Coming January, we’ll probably start seeing a lot more of such trades getting put on leading to more liquidity in these Jun 2019 expiration options.
What are the critical factors for such a trade?
These trades with far expiration cycles tend to be extremely sensitive to implied volatility. The Gamma and Theta of these options is practically zero and the options pricing is strongly determined by Vega. One needs a good understanding of how IV affects options pricing and possibly Interest Rate factors (Rho) as well. Trade these only after building a good understanding of these risks.