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Why Is A 'Long Straddle' A Good Idea Before Indian Union Budget 2012?

|Includes:iShares S&P India Nifty Fifty Index ETF (INDY), ISXIF

With the Indian Union Budget to be presented tomorrow, could there be an opportunity to trade in Nifty Options? Yes, indeed. And the opportunity could turn out to be quite promising.

Some dates to remember: 16th March 2012 (Friday) is the date of the Union Budget and 29th March 2012 (last thursday of the month) is the date of expiry of March 2012 Option contracts.

Nobody can be sure of who the Budget is going to favour. It could be positive for the market or negative. And all the benign talkers on TV try to answer the anchors in their best possible way to run their shows which will put us, the innocent onlookers in a more ambiguous situation. So, when we can't give a definite direction to the market post-budget, it's best we take a position that is completely independent of the direction of the market and possibly make money out of it. Though we dont have an idea of the direction, historically, the maximum change in Nifty from the budget date to the next expiry date is quite decent in either direction. So, we can fairly assume that the move post budget is going to be big as it always is.

For an options trader, the choice of strategy is a no-brainer. For others, I'm talking about going long on a Straddle. And for the interest of all, I'm going to tell you the cost and choice of strike, etc. to be taken. A long straddle strategy is when you buy a Put Option and a Call Option of the same expiry and at the same strike. Currently, there are 51 different Nifty Option Contracts being traded which would expire in the month of March (near month contracts). Out of these, the ones with a strike price around the current Nifty Spot Index are highly liquid and the liquidity slowly dries out as the strike moves away from the spot in either direction. Lower the liquidity, higher the inefficiency in price determination. Meaning, we are ok having a strike that is even somewhat closer to the spot, but yes, closer to the spot.

We're now going to see, firstly, how has this 'pre-budget straddle' worked in history, which strike to choose and why, when to book your profit/loss. Yeah, offcourse, there could be a loss. There is nothing called '100% probability of profit' in stock market. But, definitely we can identify strategies with bear minimum losses and with a good potential of profit.

How has the pre-budget straddle worked in history?
Answer to this question is the most important part of this read. To evaluate the performance of this strategy, we need to consider two dates, and the Nifty levels on these 2 dates. The first one is the day just before the 'budget-day' because, since you're strategy is based on this event called budget, and since option prices reduce with time due to the gravity of the greek, 'Theta', (Time-Value of Option prices) you dont want to pay a higher price taking the position some days before the budget. Rather, take it just the day before the event and save on time-value (Theta). And, the second date (the date on which you'd square off your position) could be 'the budget-day' (T0), the day next to the budget-day (T+1) or T+2 or T+3 or T+9 (T+9 is the expiry date, 29Mar2012) or even the expiry date of the contract (the last thursday of the month). The reason why I mentioned T+1, T+2, T+3, etc, is because it usually takes a few days, for the market to digest this huge information in the budget and it could actually end up giving a fair price to the stocks after some days of nervousness and jitters.

So, what should it be? T+1, T+2, ...? To determine this, let's take a look at the cost of the Option straddle, for which we should answer the following question.

Which of the 51 strikes (contracts) should I choose?
As I said before, or as we know it, a long straddle is buying a put option and a call option of the same strike and the same maturity, which means, our expense is going to be the sum of the cost of both the options. Among the Nifty options as on 14Mar2012, the cheapest straddle is the one with the 5500 strike (Rs. 221.30). Here's the breakup; Nifty Mar2012 5500 Call = Rs. 114.8 and Nifty Mar2012 5500 Put = Rs. 106.5. And yesterday (14Mar2012) Nifty closed at 5463.90. Does it ring a bell? Well, it isn't a surprise. But, our beloved 5500 is the closest contract to the spot!

Now, let's see some simple maths. Rs. 221.3 can also be said as, 4.05% of the spot (221.30/5359.55). So, on the expiry date, if the spot is greater than 5685.2 (which is 5463.90+ 221.30) or spot is lower than 5242.6 (which is 5463.90-221.30) we'd be in the money at expiry, meaning profit. That is, the Nifty spot should have decreased or increased by atleast 4.05% at expiry. But, would it change that much? We don't know. But we know a better question. Does it have to?? Although we're not bothered about what it is going to be on the expiry date, historically, it has changed by more than 5% post-budget, either up or down, every time. Considering history (take a look at the table below), 4.05% is an easy target!!


Budget Date (T0)

% Chg from T0 to ExpDate




























If the table is inspirational you can hold it upto maturity. But, read on to square it off before!

Just a reminder, we're yet to find out our second date (the square off date).

The position will be profitable if Nifty changes by more than 4.05% at expiry date. What if Nifty changes by that much before the expiry date itself? Assuming Nifty is at the same level, say, +4.05% change from T0, the cost of the straddle, say, at 5 days prior to expiry will be much higher than the cost of the straddle on the day of expiry due to the time value (5 days of Theta). In fact, the cost of the straddle could be positive if Nifty has changed by just 3.5% itself 5 days prior to expiry.

This means, the square off date shall fall within just a few days, because, T0 is a friday and participants have saturday and sunday to cool off post-budget and read the budget upto its fineprints. Also, with 29th March being the expiry date, we dont have much time before expiry post-budget (just 2 weeks) and Theta losses are very high during the last week. Considering these 2 factors, typically I'd choose the mid-week, i.e, T+3, 'The Wednesday' (21Mar2012) as my square off date. The strategy is nothing but making a safe bet on the budget.

Now, what if the market got nailed at where it was pre-budget and forgot the meaning of volatility? In that case, the Delta of the option would not have helped us as the market is stable, whereas we'd be losing on the Theta. So, it would be wise to square off your straddle booking a loss in 3 days which can't be too much, as there would still be good amount of Theta left and since budget-days are one of the most volumous days of the year, the volatility of the options immediately post budget would defnitely be high which would also keep option prices higher than at normal situations. So, T+3 is a reasonable amount of time for the market to give-in fairly to the effects of budget and at the same time not entering the last week of the contract to escape from the Theta devil.

In summary, take a Nifty Mar 2012 5500 Straddle (one lot should cost around Rs. 12000) on 15th March (Thursday), wait until 21Mar2012 (following Wednesday), before which I believe there should be a favourable exit.

Dhiraj Shekar

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.