In November 2015, we decided we wanted to showcase that market-neutral options strategies can deliver market-beating returns with very little volatility. We closed the 12th set of positions last month, gaining in total 27.26% over the year.
A fat-spreadsheet moment forced us to exit our last set of positions for a loss of -2.73% — our first losing experience. We’re now in a fresh set of positions in StratOptions 2.0, our second year with a market-neutral options portfolio. As we redesign how we use options holistically in our overall asset allocation, let’s look back at what transpired in November and what we’ve learned so far selling options.
November: tempest in a teapot?
It’ll be very hard to trade options in this fashion without perspective. What are we doing? We’re selling options to take advantage of the fact that NIFTY stays within the range the options markets expects about 73% of the time. To save ourselves from the remaining 23% of times when NIFTY moves beyond its expected range, we manage positions actively following some simple principles and use a hard stop as a last resort.
In November, we took a hard stop. We shouldn’t have, but our faulty spreadsheet spooked us with a higher -ve P&L of close to -4% (it was actually only -2.7%), which is where we draw the line. The first leg was entered on Nov 7. We exited the final legs on Nov 16. In these 9 days, NIFTY went from 8500 to 8000 to 8600 to 8100. That’s 500 down, 600 up and 500 down again. After we exited, it further fell another 200 points to 7900 before bouncing up again.
We began the position on Nov 7 with a Ratio Spread (-150 DEC 8100 PE, +75 DEC 8200 PE). The view was NIFTY won’t expire below 8000 in December and should it fall in case of an adverse reaction to the US Presidential Election the next day, IV’s would rise and we would add to our position by selling an ATM Straddle. Just to be safe, we hedged our initial position on Nov 8 by buying a Put (+75 NOV 7900 PE).
On the evening of Nov 8, Prime Minister Modi announced Demonetisation. On Nov 9, it became clear Donald Trump would be the next US President. A surprise victory, and a surprise on our currency. Markets don’t like to get surprised. Sell first, ask questions later. That’s what happened. NIFTY opened gap-down, fell to almost 8000, but bounced back to 8350 within an hour and seemed to settle down around 8250 by noon. IVs had spiked up. India VIX was trading around 20, up from 16 when we had placed our first position on Nov 7.
Instead of a Straddle, this time we sold a Strangle ( -75 DEC 7700 PE, -75 DEC 8600 CE) for a credit of 130 points. This made our overall position delta-neutral. By late afternoon, NIFTY had moved up rallying hard and was back to 8400, at which point we dumped our NOV 7900 PE hedge, not wanting to lose any money on it. To stay close to delta-neutral and move with the market, we also rolled up the short DEC 7700 PE to DEC 8100 PE. Our position at this time was: -225 DEC 8100 PE, -75 DEC 8600 PE.
The next day, on Nov 10, NIFTY almost hit 8600. At this point, out position was effectively the equivalent of an ATM straddle, but with a skewed risk profile as were short 3 lots of DEC 8100 PE. So, on NOV 10 morning, we simply closed all legs and sold the ATM straddle instead (-75 DEC 8600 PE, -75 DEC 8600 CE). We had broken even.
On Nov 11, as markets digested the impact of demonetisation and a likely slow down in consumption, it gapped down again and kept falling for a while. In times of volatility, we’ve learned to move with the market. This time, we rolled down the short DEC 8600 PE to DEC 8500 PE. We also added another short straddle (-75 DEC 8300PE, -75 DEC 8300 CE). At this point, our breakevens were 8100 and 8750.
On Nov 15, NIFTY went below 8200, our P&L was borderline -2% and it was time to make another adjustment. We resorted to our tried and tested defence method: Convert straddle/strangle into an inverted strangle. We rolled down the short DEC 8500 CE to short Dec 8000CE.
On Nov 16, we made one final adjustment. We rolled down the short DEC 8300 CE to short DEC 8100 CE. As NIFTY showed no sign on recovering, and a faulty spreadsheet overstated our P&L (showed -4.3% vs actual -2.7%, because our sum() function forgot to add the last two rows #facepalm), we decided to close down our positions and book our first losing month.
This is how the pay-off looked at that point:
That’s a lot of positions, but we hope this commentary helps you make sense of why we do the trades that we do, and figure out ways to improve them for your own trading. This is the final trade log when we closed all legs.
What if we had stayed on?
Some of you did. After we booked the position, some of you alerted us that we had recorded the wrong P&L. But remember, NIFTY went down to almost 7900 on Nov 21? Surely we would have booked the loss then? Turns out, no. If we stuck to -4% as our hard-stop, even as NIFTY approached 7900, the maximum -ve P&L was restricted to -3.5%. Here’s how the trade log would’ve looked at 3:15pm on Nov 21 when NIFTY was at 7928.
Finally, what’d be the P&L as of today, Dec 7, if we continued to hold? A gain of 2.68%.
Let’s recap. When we put on the first trade on Nov 7, NIFTY was around 8450. Even at the maximum adverse excursion point when NIFTY was at 7928 or -6.2% lower, our position’s MTM loss was only -3.5%! This personifies how market-neutral strategies can be uncorrelated to the market’s general moves and why they deserve a place in your overall asset-allocation strategy.
What have we learned?
These are some things we’ve learned in general. Consider these as notes. We’ll try and crystallise them into objective IF-THEN guidelines and provide you deeper research over the next few months to help you trade more mechanically
1. Markets move from balance to imbalance to balance
This is a concept from the Auction Market Theory (a framework to interpret market behaviour), which says that financial markets are a continuous auction process and they move from balance — spending time in one place as buyers and sellers agree on one region as value — to imbalance, where one side or the other tips the balance to move the market in one direction, to balance again, where a new value is found. We move with the market when it’s imbalanced, and try to benefit from time decay of options as it finds balance.
2. It’s the payoff, stupid!
We trade payoffs. They’re visual. They provide context. And they make it easier to think in abstraction about the very complex instruments.
3. When in doubt, go delta-neutral.
Volatility is a beast. It can throw you off your game easily. We need frameworks to guide us when shit starts hitting the fan. With selling options, we’ve learned that when you’re in volatility-induced doubt, make your positions delta-neutral, i.e. your breakevens are equally distant from current price of NIFTY on either side.
4. Don’t move the losing leg
Instead, move the other legs around. In case of Straddle, this means converting it into an Inverted Strangle by closing the winning leg and selling an ITM option instead.
5. Use a hard stop as a final risk-management measure.
At some point, you have to quit your position. You don’t want to lose more than you can digest. We’ve figured that 4-5% on capital is a wide enough stop to keep you in positions long enough to benefit from theta after adjustments post volatile moves. The principle is, keep it at 2x the average monthly return.
6. Learn to use Diagonal Spreads
They can be incredibly useful! Think of it as picking up free puts by buying OTM Diagonals after market selloffs to hedge your stock portfolio. We’ve written about diagonals in earlier posts and will integrate them into our new version of the momentum portfolio.
7. Keep expectations low, be conservative with positions size
While we started with targeting 3-5% a month, we’ve achieved 2.27%. Going forward, we believe 2% a month is a more reasonable number to try and achieve. (Hey, interest rates are going down!)
The underlying assumption is one can make 0.75% of the contract size. For a Nifty at 8000, that’s about 60 points on an ATM straddle. The position size, in terms of how many lots of ATM Straddles, can be determined using this formula (assuming a target of 2% monthly return): ( Capital / Contract Size ) * 2.67
For example, if the idea is to make 60 points off the Nifty, then one contract will yield use Rs. 4500. (60 x 75) This is 0.75% of the contract size – each contract of the Nifty is 8000 x 75 = 6 lakh approximately. Adjust this up for the exact Nifty. If you have a capital of Rs. 300,000 and you want to make 2% a month, you want to earn Rs. 6,000 a month. One contract gives you Rs. 4,500 in profit as a target. The number of lots then is 6000/4500 = 1.33. We simplify this on a different route: So the formula here is to take Capital/Contractsize * 2.67 = 300,000/600,000 * 2.67 = 1.33.
We’ll write a more detailed post on positions sizing later this month. If you have questions, ping us in the #strategic-options channel on Slack.
Now, tell them about it: