Tag: volatility

Butterflies

Introduction

The butterfly can be used to bet on underlying volatility and is cheaper than straddles and strangles and without the unlimited risk.

Bearish outlook on volatility

A long call butterfly can entered when you think that the underlying stock 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 trading at 6780, that means entering into an April 6700/6750/6800 Long Call Butterfly. If the Nifty ends between 6712.00 and 6788.00 at expiry, you make a profit of Rs. 1900.00 and your downside (max loss) is limited to the premium you paid (Rs. 600.00)

April NIFTY 6700-6750-6800 Long Call Butterfly

April NIFTY 6700-6750-6800 Long Call Butterfly payoff
April NIFTY 6700-6750-6800 Long Call Butterfly PL

The same outlook can be expressed using puts. For example, with the Nifty trading at 6780, you can enter into an April 6700/6750/6800 Long Put Butterfly. If the Nifty ends between 6707.75 and 6792.25 at expiry, you make a profit of Rs. 2112.50 and your downside (max loss) is limited to the premium you paid (Rs. 387.50) In this case, the Long Put Butterfly makes more sense: it costs less, the expected P&L is higher and the break-evens are wider.

April NIFTY 6700-6750-6800 Long Put Butterfly

April NIFTY 6700-6750-6800 Long Put Butterfly payoff
April NIFTY 6700-6750-6800 Long Put Butterfly PL

γ: runs from positive to negative. γ is negative when the stock is at the middle strike. This indicates that the butterfly will manufacture negative δs if the stock price rises, and positive δs if the stock price falls. This is precisely what you don’t want to happen. That’s why the long butterfly wants the price of the stock to stay right where it is when it’s at the middle strike.

θ: positive when the price of the stock is at the middle strike, indicating that time passing helps the long butterfly reach its maximum value. At the outer strikes theta is negative, indicating that the butterfly is losing value as time passes.

κ is negative when the stock price is at the middle strike. That means that any increased implied volatility in the stock will decrease the value of the butterfly. κ is positive for the long butterfly at the outer strikes. Therefore, an increase in the implied volatility of the stock increases the value of the butterfly because of the greater likelihood that the stock will move toward the middle strike by expiration.

Bullish outlook on volatility

A Short Call Butterfly allows you to collect premiums if you can wait out uncertainty. For example, with the Nifty trading at 6780, you can enter into an April 6700/6750/6800 Short Call Butterfly. If the Nifty ends below 6712.00 or above 6788.00 then you lose Rs. 1900.00 (difference in strikes – premium received). Otherwise, you get to keep the option premium you collected (Max: Rs. 600.00)

NIFTY April 6700-6750-6800 Short Call Butterfly

NIFTY April 6700-6750-6800 Short Call Butterfly payoff
NIFTY April 6700-6750-6800 Short Call Butterfly PL

The same view can be expressed using a Short Put Butterfly. For example, with the Nifty trading at 6780, you can enter into an April 6700/6750/6800 Short Put Butterfly. If the Nifty ends below 6707.75 or above 6707.75 then you lose Rs. 2112.50 (difference in strikes – premium received). Otherwise, you get to keep the option premium you collected (Max: Rs. 387.50)

NIFTY April 6700-6750-6800 Short Put Butterfly

NIFTY April 6700-6750-6800 Short Put Butterfly payoff
NIFTY April 6700-6750-6800 Short Put Butterfly pl

θ: helpful when the position is profitable
δ: greatest around the outer strikes, zero around the middle strike
κ: volatility is helpful, unless the underlying moves outside the outer strikes
γ: peaks positively around the middle strike and negatively around the outside strikes

Trading butterflies

You should know the historical volatility of the underlying and its distribution before you get into volatility trades. As a rule of thumb, always try to position your derivative book towards being long volatility.

If the bid/ask spread is too wide, it can affect the quality of the trade. Since the losses are capped, running this trade to expiry may be tempting in such a scenario.

Source: ThinkOrSwim

Understanding Nifty Volatility

Definition

Volatility (σ) is a measure for variation of price of a financial instrument over time. Historic volatility is derived from time series of past market prices. There are different ways of calculating volatility. At StockViz, we use Yang Zhang Volatility.

σ is one of the biggest contributor of option premiums. Understanding its true nature will help you trade it better.

Volatility spikes

Observe the volatility spikes since 2005. Even though the average is around 0.3, its not uncommon to have huge swings.

nifty-volatility

Fat tails abound

nifty-volatility-10-histogram

nifty-volatility-20-histogram

nifty-volatility-30-histogram

nifty-volatility-50-histogram

Trading strategy

Always try to be on the long-side of volatility. It might be tempting, while trading options, to try and clip the carry on θ-decay. But you should always be aware of the fat-tails of volatility that can crush many months of carry P&L overnight.

USDINR Implied Vol vs. Realized Vol

Does implied volatility contain incremental information about future volatility? At least according to this paper, it does.

Here’s a chart that plots USDINR option implied volatility (nearest at the money) vs. futures (nearest expiry). It does appear that IV leads realized vol, but it would be interesting to see if there’s any trading edge here…

USDINR Option Implied Vol and Futures Realized Vol

[stockquote]ATULAUTO[/stockquote]

Technical Analysis on VIX – Does it make sense?

You can view a chart of the VIX just as you can for any stock or index. Just go to the VIX page, add some moving averages, maybe even Bollinger Bands and RSI indicators and you are on your way. However, just because you can chart the VIX just like a stock, doesn’t mean you should actually read the chart just like a stock.

India VIX analysis

Charts for stocks and indices actually represent buying and selling over specific timeframes. Stocks gap up and down. Gaps get filled. Old resistance points can become new support levels, etc. However, VIX is not a stock. India VIX is a volatility index based on the NIFTY Index Option prices. From the best bid-ask prices of NIFTY Options contracts, a volatility figure (%) is calculated which indicates the expected market volatility over the next 30 calendar days. Hence, price points for the VIX doesn’t correspond to potential profits and losses of actual trades based on those levels. Support and resistance and trend lines and momentum effects all depend on the existence of buyers and sellers in the asset being analyzed. But you can’t trade VIX directly, so the VIX can never find “support” because no one previously bought VIX “shares” at that price level. VIX is, at best, an indicator of market expectation of volatility.

However, there are a few useful analysis you could run on VIX, given its tendency towards mean-reversion. Bollinger Bands and moving averages could help you gauge the band within which VIX is oscillating. Longer-term charts could help surface seasonal patterns. StockViz India VIX Charts are another tool in the arsenal for investors to help them make better decisions.

Time to buy Volatility

Now that the earnings season is over and Europe is on vacation, volatility in the NIFTY has dropped off. Here’s a historical chart to put things in perspective:

image

With the August expirations right around the corner, you should be looking at putting on Sep 5300/5400 Long Strangle on the NIFTY or if you are feeling brave, buy the Sep 5000 NIFTY Puts outright.

With the Strangle, you’ll have some protection against melt-ups. If you look at the pay-off at expiry, you are protected if Europe gets its act together or if the domestic situation improves. With break-evens at 5,118 on the downside and 5,581 on the up, a move outside of any one of these goalposts will make you money.

Whatever your strategy is, volatility seems too low at this point. So make sure you put some “reversion to the mean” trade on.