Category: Investing Insight

Investing insight to make you a better investor.

Selling NIFTY Butterflies

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Nifty Rolling Returns

In our earlier post, we saw how selling NIFTY butterflies has been profitable this year. To understand why, let’s have a look at the rolling returns of the NIFTY.

Here’s the 30-day rolling returns of the NIFTY, from 2010 to the present, the whole population:

day-30-rolling-2010-2015
Median: 1.57%

2014-present:
day-30-rolling-2014-2015
Median: 2.18%

Beginning of 2015-present:
day-30-rolling-2015-2015
Median: -1.08%

Profitability

For a short-call butterfly to be profitable, NIFTY has to expire away from the either of the wings. Each wing is 100 points away. With NIFTY at 8500, that’s a 1.12% move. Whereas back when NIFTY was around 6000, this trade would require a 1.67% move to be profitable. So as the NIFTY rises, if they don’t widen the distance between the listed strikes, your hit ratio with selling butterflies will increase. However, the total profitability will decrease because everybody will think this way.

Summary

If NIFTY continues to exhibit the same pattern of returns, a rising NIFTY will make selling butterflies more profitable.

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Butterfly Option Strategy – Introduction

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What is it?

An option butterfly strategy can be used to bet on underlying volatility. A long call butterfly can entered when you think that the underlying will not rise or fall much by expiration. Using calls, the long butterfly can be constructed by buying one lower striking ITM call, writing two ATM calls and buying another higher striking OTM call.

For example, with the NIFTY at ~8330, the strikes would be 8300, 8400 and 8500. If the NIFTY bends between 8310 and 8490, you make a profit of ~Rs. 90 per contract (x lot-size) and your downside (max loss) is limited to the premium you paid (~Rs. 10 per butterfly contract x lot-size.)

To get a sense for how your P&L will look, you can project the option premiums using the Black-Scholes model.

butterfly.NIFTY.2015-07-08.2015-07-30

The solid black line is the P&L scenario at expiry. As you can see, intermediate P&L bears very little resemblance to expiry. It is almost as if most of the P&L is “pulled” as you get nearer to expiry.

Projection vs. Reality

Back in early April this year, the NIFTY was trading around 8600. So you would enter into an 8600, 8700, 8800 butterfly. If you sold the June butterfly, you are essentially betting that the NIFTY would expire outside of 8605 and 8795. If it did, you would get to keep the premium you received (~Rs. 5.70 per butterfly.)

butterfly.NIFTY.2015-04-06.2015-06-25.6.7.8.projection

Here is how the butterfly actually behaved:

butterfly.NIFTY.2015-06-25.2015-06-25.678

As a seller, your P&L is actually the inverse of what is shown above. So you would have lost a lot of money when NIFTY shot to 8800s and then swung the other way as NIFTY headed back down. Finally, as you neared expiry, your P&L approached the premium you received.

As you can see, actual behavior bears very little resemblance to modeled behavior.

Butterfly profitability

Selling butterflies has been a profitable trade this year. As long as there is volatility, a short call butterfly should make money. Here is the long P&L (selling butterflies would invert this P&L):

butterfly.PL.NIFTY

However, it is a bet on the NIFTY not expiring within the break-even range of the trade. Getting this right could prove tricky. Losses tend to be large and if risk is not managed properly, it can wipe out all the profits made over a period of time. The proverbial “picking up pennies in front of a bulldozer.”

Summary

To point out the obvious, liquidity is a huge problem while executing on this trade. However, selling butterflies can be used to systematically earn carry, as long as risks are managed.

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Optimization vs. Maximization

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The dog years of 2010, 2011, 2012 and 2013

According to AMFI, these are the 5 largest funds at the end of March-2015:

Scheme Name AUM (Cr.)
HDFC Equity Fund – Growth Option
1,280,287
HDFC Top 200 Fund – Growth Option
1,009,121
Reliance Equity Opportunities Fund-Growth Plan-Growth Option
764,383
HDFC MID-CAP OPPORTUNITIES FUND – Growth Option
715,865
ICICI Prudential Value Discovery Fund – Regular Plan – Growth
645,946

What this means is that there is at least one person in your immediate network who would have invested in one of these funds.

Now let’s take a walk down memory lane. 2010, 2011, 2012 and 2013 were the worst years for the Indian economy. The RBI had messed up monetary policy leading to high inflation (double digits), there was a currency panic (rupee went from 45 to a dollar to 65), a never-ending series of scams and a government hell bent on redistribution. The only two asset classes that were doing well at the time were gold and real estate. GOLDBEES, the gold ETF, returned 13.25% (IRR) during that period. Fixed deposits were yielding around 11%. How would a typical investor react if his actively managed equity investments gave the following returns?

Scheme Name IRR
HDFC Equity Fund – Growth Option
7.00%
HDFC Top 200 Fund – Growth Option
6.74%
Reliance Equity Opportunities Fund-Growth Plan-Growth Option
12.00%
HDFC MID-CAP OPPORTUNITIES FUND – Growth Option
13.24%
ICICI Prudential Value Discovery Fund – Regular Plan – Growth
11.09%

Here is Gold (in red) vs. HDFC Equity Fund (in black):

Needless to say, most investors who dipped their toes into the equity markets in 2010 gave up after a couple of years and still believe that the whole mutual fund business is a scam.

First half of 2015

We are supposed to be in a bull market. But let’s see how the first half worked out for the HDFC Equity Fund:

IRR of -2.39%. And bonds lost money too (in June.) Bull markets are not immune to prolonged periods of a “sideways” market.

Diversification across assets

A standard response to most investing problems in diversification. Invest a little into a variety of asset classes – equities, commodities, real-estate, gold, bonds – and you will be fine.

The problem with diversification is that it always feels wrong. For example, there are “balanced” funds that are supposed to allocate between both bonds and equities. They end up having lower draw-downs because of this. If you compare the ICICI Prudential Balanced Fund with HDFC Equity Fund between 2010-2013, the latter has an IRR of 11.38% vs. 7.00% of the former. But during the bull market of 2014, the balanced-fund gave an IRR of 45.47% vs. the equity fund’s 53.83%. So the lower draw-down comes at the expense of performance. It is a huge cognitive burden for investors to live with.

The kind of assets you pick for diversifying into also matters. For example, there was this big thing back in the day about the “commodity super-cycle.” About how the insatiable appetite for all sorts of commodities from China would keep growing to infinity. Plus, commodities were supposed to uncorrelated with equities. So great for diversification, right? Here’s how Mirae Global Commodity Equity Fund compares to the HDFC Equity Fund:

Commodity stocks did turn out to be uncorrelated but not in a way that you would like. And the commodities themselves are bouncing along multi-year lows right now.

What about bonds? Surely, they are safe. But let’s not forget that in 2009 and 2013, gilts drew-down double digits and their long-term IRRs are between 7% and 10%.

gilt drawdowns

Diversifying across geographies

What if you invested in international funds? After all, the rupee keeps going down, right? Depends on where you look. Between 2010 and 2013 (the dog years) the Birla Sun Life International Equity Fund – Plan A gave an IRR of 16.09% vs. HDFC Equity Fund’s 7%. But before you pat yourself on the back, between 2014 and now, the latter gave an IRR of 3.06% vs. 32.54% of the former. And Religare’s Pan European Equity Fund gave 1.50%.

Diversification means that your overall portfolio will trail behind the best performing asset class du jour. Psychologically, it is a very difficult thing to stick to.

Investing fads and broker recommendations

Of all the poor choices that investors can make, the worst is giving into investing fads. Back in 2004, there was this whole “India shining” marketing slogan. And now there is “make in India”, “smart cities”, “digital India”, etc. And almost every single time, fund houses come out with new schemes that tag along the slogan du jour. Here are some examples:

Morgan Stanley came out with their stock picks if Modi won (Theme created Dec 6, 2013):
morgan stanley strong election result

Here’s one on the Rail Budget (Theme, created Feb 26, 2015)
rail budget 2015 theme

So much for betting on rate-sensitive stocks (Theme, created Feb 3, 2015):
rate sensitive 2015 theme

You can browse through all these recommendations and lists under the “Broker Recommendations” section of our Themes page. We call it Doodh Ka Doodh Pani ka Pani.

Optimization vs. Maximization

The above examples highlight the problems of trying to maximize returns. There will always be an asset class, mutual fund or stock that is doing better than what you own. And there is an entire industry of tip-sheets, newsletter writers and subscription services that promise to pick the next winner.

However, we see investing as an optimization problem. We believe that drawdowns are an inseparable part of investing. Instead, we focus on getting the right mix of assets and strategies based on your risk appetite. And we make it supremely easy to stick to a plan.

For direct equity investors, this means getting Value and Momentum right. We have created Themes based on different approaches to value and momentum investing. Investors can then map our Themes to gain exposure to a specific set of strategies.

For mutual fund investors, this means getting portfolio risk right. We have created Themes based on the risk of the overall portfolio. Investors can now tune out the noise and focus on achieving their life goals.

Investing is not easy, but your journey as an investor will be so much more smoother with us. Get in touch with us now!

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Implied Volatility around Earnings Announcements

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Introduction

There is a common belief that option implied volatility, which is high before earnings announcements, quickly dissipates after the event. So sell options before the event to profit from the fall in IV. We decided to put this theory to test by observing at-the-money IVs 5-days before earnings announcements and their subsequent behavior.

It is not what you expect.

ATM IVs

Here are the at-the-money implied vols 5-days before and the day after announcements:

atm iv announcement

In our study, IV falls only 44% of the time. So the blanket statement fails. IV dissipation is not guaranteed. There are a lot of other things that affect IV and earnings alone is not sufficient to predict the outcome.

However, if the IV was more the 50, then IV dissipates 70% of the time. However, these odds could be similar to those without earnings announcements as well (all things equal.) So further research is required.

Conclusion

Don’t go around selling options thinking that IV will dissipate after earnings announcements. Know your odds.

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Stop-loss and Re-entry

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Introduction

A trailing stop is a percentage below the most recent high at which you exit a trade. It allows you to lock-in gains while avoiding catastrophic loss. There are lot of opinions about where these should be set. And more importantly, when to re-enter. What follows is a discussion on how different stops and re-entry rules affect trading frequency and returns.

We will consider time-series from 2010 through now on the NIFTY, BANK NIFTY and CNX MIDCAP indices. During this time, the cumulative buy-and-hold returns were 61.47%, 104.81% and 75.61% respectively.

A simple 5-3 Rule

“A good plan violently executed now is better than a perfect plan executed next week.”
– George S. Patton

To get us started, we propose a trailing-stop loss at 5% and a re-entry rule that triggers when the index covers 3% from the lowest level since exiting the trade. This rule significantly increases returns and reduces draw-downs across all indices.

nifty.stop-loss.2010.5.3

bank-nifty.stop-loss.2010.5.3

mid-cap.stop-loss.2010.5.3

Index #trades cum. returns
Nifty 139 366%
Bank Nifty 209 2291%
Midcap 159 382%
The boost in returns come at additional trading costs. And even though the average number of trades work out to less than one a week, there maybe periods where it might trigger every day.

The 5-3 Trading frequency

Let’s plot the days on which this rule triggers (both buys and sells.)

nifty.stop-loss.trades

bank-nifty.stop-loss.trades

mid-cap.stop-loss.trades

By the looks of it, the stop-loss and re-entry bands are too narrow.

The 10-5 Rule

Suppose we set the trailing-stop loss at 10% and re-enter when the index covers 5%, we end up with a strategy with lower number of trades and yet, better returns and buy-and-hold.

Index #trades cum. returns
Nifty 50 100%
Bank Nifty 103 536%
Midcap 66 162%
Lower trading but lower returns as well.

Returns:
nifty.stop-loss.2010.10.5

bank-nifty.stop-loss.2010.10.5

mid-cap.stop-loss.2010.10.5

Trading Events:

nifty.stop-loss.trades.10-5

bank-nifty.stop-loss.trades.10-5

cnx-midcap.stop-loss.trades.10-5

Trailing stop-loss and re-entry scenarios

The master list of different strategies, their trading frequencies and cumulative returns.

trailing stop-loss and re-entry scenarios

Conclusion

Having a trailing stop-loss and re-entry strategy enhances returns but at the price of increased trading frequency. No combination of strategies can escape the doldrums – where the index is basically flat and you are getting whipsawed.

With a 15% tax on short-term gains, over the 5-year period, you should handicap strategy returns by 75% to do an apples-to-apples comparison on the tax-free buy-and-hold returns. If you use the 10-5 rule, it means you will only come-out ahead trading the Bank Nifty. So you are better off with the 5-3 rule given where trading costs stand.

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