Saturday, 28 March 2009

Insights from the Options Pit: 'Vix'y 'Volcone'o

My posts seem to have a direct relationship with liquidity and credit availability in the markets...both have dried up!

In this post I draw insights from the beautiful, non-linear world of Options. The title is a grammatical mess but it captures the central idea behind this post. I make a case for increasing volatility over the next two months in the Indian markets and possible ways for investors to play this. I'm amazed at the near-term thinking manifesting even in the options world. The markets are so riveted on the near month expiry that they forget there's a next month...and a month after that. India will go to elections starting mid-April and the spectacle will be for everyone to see over a 1 month period.

As always, this time will most likely see tugs-of-word wars and plenty of ego-massages as one party tried to outdo the other in gaining the coveted majority number. Pre-election opinions point to a fractured mandate and there's a very high probability of frenetic post-poll activity. We are nearly in April but what are the markets saying?

...the markets seem to be pricing in a 'normal' situation. I define 'normal' as a period where the Nifty index volatility is around the long-run range (which roughly is the 25%-30% band). Volatility (or vols, for short) started picking up over last week and are currently in the 30%-35% band. Is there a possible opportunity?

Lets take a look at history for pointers on the possible way forward for the market over the next couple months.

Elections and Nifty behavior: Part I (Apr-May 1999)

The chart captures the Nifty index and the 30, 60 and 90-day volatility surrounding the election period in Apr-May 1999.

The period leading up to the election months witnessed quiet activity on the vols front and the Nifty was essentially flat...And then something beautiful happened...

Suddenly the markets
took cognizance of the upcoming elections and uncertainty increased, manifesting in increased volatility. Vols shot up from the 25%-30% band to the 40%-50% range through the election months of April and May 1999. The Nifty rose 6% over this two-month period.

Vols settled back to the long-run range over the subsequent months and the Nifty continued its rise, along with the general euphoria surrounding global equities around the internet bubble.

So far so good...what happened in 2004?

Elections and Nifty behavior: Part II (Apr-May 2004)
Similar pattern?

Vols were chugging along unspectacularly in the months leading up to the elections while the Nifty was in a gradual downtrend. Interestingly, through much of April 2004 Vols were flat...and then they jumped...

Once again, increased uncertainty coupled with post-poll dash for forming alliances resulted in Vols jumping from around the 20%-25% band to the 40%+ region. Th
e 30-day vol shot up to the 60% range...

The Nifty, however, dropped 18% over the two-month period...too bad for naked Call buyers.

Vols remained elevated for a while before reverting back to the long-run r

Elections and Nifty behavior: Part III (Apr-May 2009)?
...hmm... probably there's something here. Nifty Vols over March were around the 30% mark. The past week saw the Nifty mimicking the rise in global markets. And vols started rising, but they are still in the 30%-35% range. Elections begin in mid-April and run for a month leading me to make a case for increasing vols over the next couple months.

Comfort from the 'VolCone

The VolCone is a chart of volatility over varying time periods (30/60/90/250 days) for the Nifty over the past one year. The chart captures the Maximum, Minimum, Median, the 25th and 75th percentile for the Nifty volatility over the past one year.

The solid Black line is the current volatility. We see that the 30 and 60-day current vols overlap the 25th percentile line. What does this mean?
The way to interpret this is that one can reasonably expect 30-day Nifty volatility to be lower than 30% (current levels) about 25% of the time. Put another way, there's a 75% chance it will be higher than 30%. How high? I have no answer to that. This, combined with the closeness to elections, leads me to think that options are not being priced for this event. Increase in Vols generally lead to higher option prices.

The (confusing?) conclusion from the 'VolCone' chart combined with historical performance leads me to think that Vols could increase over the next couple months. Options are not pricing in the election event and once they do, there could be reasonable upside for an investor willing to bet on this occurance. Given the current conditions, I would be buying Volatility...(in option jargon, I would be 'Long Vega').

So would I do naked positions? I don't think so. I have never been able to predict market direction and find more comfort in playing my Volatility friend. I have no view on market direction but I have a reasonably strong view of increasing volatility. In this scenario, I would be inclined to putting on Strangles or Straddles, that allow me to play volatility without taking a view on market direction.

Why aren't the markets pricing it in then? I don't know. Vols have indeed starting moving up over the past one of two things could happen. Either me or the markets are getting this wrong...

If new information compels me to alter my stance...I would do what John Maynard Keynes once said, "When facts change, I change my mind. What do you do Sir?"
Cautionary statement: There is immense risk of loss of capital in options trading. Readers are strongly encouraged to counter my views and base their decisions on independent due diligence.