Trading Strategy Case Study #4

Trading Strategies 📈
1

Trading Strategy Case Study #4

Aim: Earning alpha using Government Securities and Index Options

Mechanism: The scope of the strategy is to use Government Securities as collateral and using them as margin, sell index options (NIFTY) to generate alpha. The strategy is commonly called a “Short Strangle” options strategy.

Flow:

  1. Buy Government Securities worth Rs. 1,00,000. Roughly, the yield is around 7.5% currently.
  2. Pledge them to get margin. With 10% haircut, you will get a margin of around Rs. 90,000
  3. Now sell lower strike put option and upper strike call option in NIFTY to get premium.

Follow the below mentioned calculation to identify the strikes.

Capital 1,00,000.00
ROI Required (A) 15.00%
Underlying (B) 7.50%
Additional Return (A-B) 7.50%
Additional Return in Amount (C) 7,500.00
Monthly (C/12) 625.00
Weekly (C/12*4) 156.25

Now either go for weekly, monthly or long term based on the premium needed and choose the strikes.

For weekly, we need a premium of Rs. 156.25. As NIFTY lot size is 50, we need the straddle premium of Rs. 156.25/50 = Rs. 3.13. Now go to the option chain to select the strikes such that the total strangle premium is equal to Rs. 3.13.

1
11617×729 152 KB

Similarly for monthly, the strangle premium = Rs. 625/50 = Rs. 12.5 and for annual, the strangle premium = Rs. 7500/50 = Rs. 150

2
21615×731 155 KB

As you can see from the payoff graphs that the range is too wide to get breached (black swan events are exceptions). So you will consistently make a gain of 15% if you follow this with discipline. Based on your risk profile and return expectations, you can adjust your calculations.

:bulb: Insights: In PTDs, such strategies are deployed on a large scale (around 1000-2000 lots each desk). However, as the strangle strategy carries unlimited downside risk, a strict SL of thrice the option value is placed as SL which helps to protect from any black swan events. The same can be followed as a measure of protection.

4 Likes
2

Am not a fan of overnight sell strategies with unlimited downside. Worst case risk is account khali :grimacing:

Pledging govt securities and doing expiry day otm selling with stops would be less risky.

1 Like
3

@t7support Indeed the risk exists and hence we followed a strict SL of 3 times the option value. Back then, we had SL order which used to get triggered as soon as market opens from the RMS side. However, I had rarely seen that taking place, we used to close positions on any such major events.

Expiry day OTM selling my entry point in PTDs when intraday leverage was 100x and more. Good olden days :smiling_face_with_tear:

4

SL work only when the market is live. It doesn’t protect against overnight mayhem. At market open one can exit only at available market price.

This is true. This makes sellers happy most of the time. But one really bad day which may happen once in a decade could take away years of hard earned profit.

:sweat_smile:

5

True. Sellers are rewarded premium only only because they carry the baggage of this risk. Hence, PTDs diversify their risk by allocating a big chunk of funds in different desks. I remember during March 2020 expiry, the strangle desk had losses of 47 cr. However, the other desks had managed to be profitable and overall the expiry ended positive. Having said this, this equation doesn’t work for the retail where the capital is limited. PTDs enjoy almost infinite capital.

Yes. The logic was as soon as the market opens, buy order was placed at thrice the option premium. The very first order from our desk.

2 Likes