Our previous post discussed how the implied volatility (IV) of OTM puts are often higher than the IV of OTM calls. We would like to add that this “smirk” is very much warranted – it is not an invitation to sell OTM puts. Returns of financial instruments often have negative skew – a fancy way to say that they often take an escalator up, and an elevator down.
Here are the daily and weekly return skews of the NIFTY 50 TR index and the SPY ETF:
The market is willing to pay up to hedge against this risk. If you sell the skew, you’ll have to hedge against it by some other means. Otherwise, it is like picking up pennies in front of a bulldozer.
When you use the Black-Scholes-Merton (BSM) model, you end up with theoretical prices that assumes that volatility affects all strikes uniformly. i.e., strikes have no bearing on implied volatility (IV). This was largely true in the market as well until the crash of 1987. However, after the October 1987 crash, the implied volatility computed from option prices using the BSM model started differing between puts and calls. This is called “volatility smile“, or the smirk, given its actual shape.
The reason for this is quite simple, markets take the stairs up and the elevator down. Fat tails, if you must. So, put options sellers require a little bit of an incentive to take on that risk.
How crooked is the smirk? If you take the ratio of the IVs of OTM puts to OTM calls and plot them, you’ll notice that as you get farther away from spot, the distribution flattens out.
Notice the area below 1.0? Those are the days when the calls were trading at a higher IV than the puts.
On the left of zero are the calls with descending order of strikes and on the right are puts with ascending order of strikes. The farther away from zero, the more OTM they are.
Also, unlike the stylized charts of IV you might have seen with sweet smiles, the reality is quite different.
If this tickles your curiosity, do read The Risk-Reversal Premium, Hull and Sinclair (SSRN)
At the launch of Nifty Midcap Select Index futures, we had pointed out that strategies that work on the broader Midcap 150 index should work on it as well. Since then, MIDCPNIFTY has had a colorful journey with the exchange experimenting with different tenures and expiries. However, the experimentation phase seems to be over and volumes have steadily improved with the product finding decent traction.
Some quick thoughts on liquidity:
Simply don’t trade the opening and closing stubs and you are golden.
Also, stick to the nearest expiry – the spreads on the other two will make your eyes bleed.
The tightest spreads can be usually found around 15 minutes to close – great if you are taking positional trades end-of-the-day.
On the face of it, MIDCPNIFTY futures look good enough to trade. Happy hunting!
India VIX is a volatility index computed by NSE based on the order book of NIFTY Options. For this, the best bid-ask quotes of near and next-month NIFTY options contracts. India VIX indicates the investor’s perception of the market’s volatility in the near term i.e. it depicts the expected market volatility over the next 30 calendar days. Higher the India VIX values, higher the expected volatility and vice versa. (NSE)
Does the actual volatility come close what the VIX was implying 30 calendar days before? Not always and probably never.
What if it’s pricing something more immediate? Here’s the regression with a 10-day lag:
Regression with no lag:
The relationship between implied and historical is one of those things that are directionally true… sometimes.
Does trend following work on bonds? According to alphaarchitect, it should. However, they use data going back to 1928 and we wanted to look at something more recent. Also, we wanted to check if it worked for Indian bonds?
For Indian bonds, you are better off buying and holding. Once you consider transaction costs and taxes, there is no benefit.
For US, we ran the same SMA scenarios on the TLT (20+), IEF (7-10), SHY (1-3) and AGG etfs. There is some benefit to applying a 100-day SMA filter on the first three. However, the after-cost benefits are questionable.
