Invest Without Emotions
Summary: Mar NIFTY 18000 calls added 65,14,850 contracts while 17400 calls shed 44,21,500. On the Put side of the equation, the 17500 strike added 80,10,000 while the 16850’s shed 4,60,800.
Dotted lines indicated actual underlying volatility. Solid lines are IVs.
SEBI, in its infinite wisdom, concluded that retail investors are speculating too much with derivatives because exposures are too low. So they decided to increase the minimum exposure to Rs. 5 lakh per contract. You can read their press release in the appendix below.
Anybody who trades naked derivatives will see their margin requirements go up. As you can see from the chart above, most of the exposures are below the new Rs. 5 lakh threshold. Lot-sizes of MRF, BOSCHLTD, EICHERMOT and PAGEIND will come down, but that is of little comfort.
For exposure margin, you can always buy a bond fund and pledge it with your broker. This way, your margin cash will earn something while it is with your broker.
Second, you can always use option strategies to execute the same view. For example, the total margin requirement to enter a trade in NIFTY futures is around Rs. 17,000/- right now. But when the new regulations kick in, it could go up 3x to 51,000/- Suppose you want to express a bullish view on the NIFTY, instead of buying a naked call or futures contract, you can enter a bull spread to lower the margin requirements.
Here are the numbers from the Zerodha SPAN calculator.
The bull spread has lower up-front margin requirements than the naked futures contract, with the added benefit of bounded profit and loss – resulting in lower mark-to-market margin requirements. Traders can use the pledge + spread strategy to bring down their net margin requirements.
The net effect of the new regulation could be that naked positions in the futures markets may be replaced by strategies in the options market. The total risk in the system remains constant – like a water balloon, if you squeeze it in one place, it will pop out in another.
We expect retail futures trading volumes to drop and options volumes to pick up once these changes go into effect.
The biggest problem with any trend-following strategy is sudden reversals in trend. This fits nicely into the biggest problem with selling butterflies – that the underlying stays where it is. One thing that momentum stocks guarantee is that they will move big.
Our earlier attempts at developing a mechanical short-call butterfly strategy for the NIFTY failed because there would be months when the NIFTY would just end flat for expire very close to where it started after bouncing all over the place. Let’s see if using single-stock options overcomes this problem.
In order to hedge our bets, we consider only the top 3 and the bottom 3 stocks in our momentum universe. And then we apply a liquidity filter to ensure that we can actually carry out the trades. Trades are entered 10 days after expiry and held till expiry. No stop-loss is applied.
Using momentum to drive a short-call butterfly strategy holds promise. We have created a Theme for it – Shattered – to help traders access this strategy.
In our previous post, we saw how a mechanical expiry-to-expiry short-call NIFTY butterfly with a stop-loss significantly outperformed a non-stop-loss strategy. However, the odds that a stop-loss would be triggered was almost 50%.
In our introductory post on butterflies, we had noted how the strategy P&L gets “pulled” as we get closer to expiry. This implies that during the first half of the trade, the position sits idle. However, the underlying NIFTY index could have already made its move out of the wings and could be on its way back to the center. To avoid this, we can delay entry until, say, 10 days have passed since expiry.
Although on the face of it, selling butterflies on the NIFTY sounds attractive – NIFTY is a volatile index and a rising NIFTY will make the moves required for a profitable trade lower – a mechanical backtest did not lead to a strategy that could be applied on an on-going basis.
We saw earlier how infrequent but large losses in the short-call butterfly strategy can wipe out all the past profits earned. To figure out a stop-loss mechanism, we plotted individual expiry-to-expiry butterflies to find out how each one of them behaved. This data is available in the appendix below.
The stop-loss is set at 10 points (x lot-size) for the butterfly. But this kicks in only 10 days before the contracts expire (see how it gets “pulled” here.)
Here’s the month-over-month returns of a mechanical short-call butterfly strategy with stop-loss:
Here’s the month-over-month returns of a mechanical short-call butterfly strategy without stop-loss:
Because of the stop-loss, the frequency of losses increases but their magnitude decreases. However, stop-losses were hit about half the time.
Applying a stop-loss to a mechanical expiry-to-expiry short call butterfly strategy on the NIFTY seems to enhance returns by cutting out infrequent but large losses. However, the frequency of wins seems low given that only two out of 5 years resulted in net profit. If you did not use a stop-loss, you would have larger gains and would have had more positive years. However, losses in 2010 and 2012 were enough to wipe out all profits and more.
https://www.scribd.com/doc/271141815/Nifty-Butterfly