Another low-IV month and we continued to use ratio diagonals, as we did in August. A big gap down on 12th September rattled us. As we’ll see, the ratio was too aggressive. With some adjustments, some patience, and some mean reversion in price, we managed to survive. And a separate Bank Nifty trade helped us top-up our returns and reach 2% in September. Let’s break down the trades:
On Sep 7, we initiated a diagonal ratio spread using puts by selling 300 Sep 8600 Puts and Buying 150 Oct 8500 Puts. As the market was strongly trending up, we didn’t want any upside risk, and keep the lower breakeven close to the -1SD level (as derived from VIX). This is how the pay-off stood:
On Sep 9, we added another set of legs. Another ratio diagonal but this time using calls, effectively creating a short strangle like pay-off, but one that would benefit from rising IVs. We sold 150 Sep 9100 Calls and bought 75 Oct 9200 Calls. The breakevens now for the entire position were still close to the +/- 1SD range, which is what we always strive for. Here’s how the updated pay-off looked:
Then, things turned south. The position was perfectly fine, as we now know in hindsight. But once Nifty gapped down 1.5% on Sep 12, potentially creating what is known as an ‘Island Reversal’, it forced us to relook our downside risks. Our MTM loss reached close to Rs 5,000 and any follow through on this bearish move would’ve left us too vulnerable.
The existing legs had already consumed most of our margin capacity of Rs. 3L. So we needed to free up some of it and hedge our downside to extend our breakevens lower. We covered the Call legs, booking a gain of Rs. 500 on them and bought two lots of September 9000 Puts. This dramatically changed our pay-off. The problem was, our upside breakeven was only 50-100 points away. Here’s how the pay-off looked:
As we write this, Nifty is close to 8700 and had we continued with this adjusted position, we’d have reached our 3% target, but in the process, we’d have experience a period of MTM losses as Nifty bounced back to 8900 between Sep 12 and now, before declining again.
And had we kept our original position of two ratio diagonals, we’d be up close to 2%. Similar to what we achieved.
But we realised a breakeven just 50-60 points away on the upside was too close. So wescratched out of the long put position for a small loss, offsetting any gains we had from the earlier Call diagonal.
When in doubt, become delta-neutral: And that’s what we did. Buying a Put made it too risky on the upside. But we needed to have some cushion should Nifty fall further. So, we sold 75 Sep 8800 Calls. This would mean we were effectively short an ATM Straddle. You can imagine the pay-off now, that inverted V, with a short 8800 call (Sep) and short 8600 puts (Sep) with an offset of a long 8500 puts (Oct).
Few days later, on Sep 16, Nifty had bounced back and hit a high of 8847. Now we needed to protect our upside again. We had to made a final set of adjustments. We squared off the long Oct 8500 Puts for a profit, and the short Sep 8600 Puts. And we sold 75 Oct 8900 Puts.
Effectively, this meant we were short an inverted strangle (8800 Calls and 8900 Puts, both ITM) + Short Sep 8600 Puts. Here’s how the pay-off stood. Now, we waited for the rest of the month to play out.
On Sep 22, we exited all legs and recorded a profit of Rs. 4,000, which is a 1.3% return on the Rs. 3,00,000 allocated to the strategy.
The BankNifty Kicker Gets Us To 2%
On a lonely Friday, the BankNifty looked boring. And there’s a way to benefit from Boring. The Calendar Strangle – we’ve done this before.
• We sold the 20,000 strike call+put (September) for a total of 315
• We bought the 20,000 strike call+put (October) for a total of 792.
• Margin of Rs. 120,000 of which about 18,000 was a cash payout since it’s a net payout trade.
One lot only. The idea was to benefit from relative time decay. By the end of the day, guess what happened?
The September straddle (call+put) was at 284 – a profit of 31 points. Which makes sense – it would expire in a week so it lost time value by the end of the day. But remarkably the October 20,000 straddle was at 810, which is a further profit of 18 points. The October options had gone UP in value – time decay is much lesser per day if you have five weeks left, and perhaps the feeling about the RBI policy in early October drove up prices.
We booked it. Yes, intraday – but we looked at the position once at 10 AM and then at 3 PM. It’s hedged so it’s not worth screen time.
That’s a profit of 49 points or Rs. 1960 per lot.
We add this to the 4113 on the other positions for a total profit of Rs. 6073 for the month. On the capital allocated of Rs. 300,000, we make about 2%.
1. Don’t be too aggressive with ratios: Our 2:1 Ratio was too aggressive. This meant that a sudden drop led to a bigger MTM loss very soon. A 3:2 ratio would’ve been much easier to handle psychologically, though the payoff might not have looked as sweet. This means, instead of being short 300 Sep 8600 Puts and long 150 Oct 8500 Puts, we should’ve been short 225 Sep 8600 Puts, and long 150 Oct 8500 Puts.
2. Stick to selling: Buying the Sep 9000 Puts was a bad decision. The best defence was what we did later: becoming delta neutral. Had we left the position as it is after selling the Sep 8800 Calls, we’d have reached very close to our 3% return target.
3. You’re trading the pay-offs: Regardless, we survived the volatility and ended up with a profit. The takeaway for you should be that when trading strategically, you’re always trading the pay-off, not technical levels. You’re trading probabilities and should always try to keep your breakevens close to +/- 1SD levels. That’s our edge.
We made 27% in 10 months
The total returns since we started is 27% in 10 months. We haven’t seen a losing MTM position for more than 14 days, and we’ve made money in upmoves and downmoves. The ideas here are easy to implement and scale, and if you have the risk taking ability, this is a good skill to have in times when fixed-income strategies might not have much of a yield. But you have to build it over time -we are demonstrating this in real time.
Note: We put most of the money in a liquid fund (Liquid Bees) and use it as margin to fund the positions. We earn 0.4% or so per month on LiquidBees, but we don’t account for it – because that will pay for brokerage etc. (Rs. 1200 per month should be more than enough for brokerage costs).
All of this is discussed in extreme detail, in Slack at #strategic-options. Positions are in#actionable.
Note: the Nifty VIX is horribly low, staying below 15 for most of the month. Markets are not supposed to be like this. There will be a big move in either direction. Shorting straddles and strangles should be done with super care, and with the knowledge that in this market a big move is expected and natural.
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