Option Strategies: Navigating the Volatility Wave During Budget Days

The upcoming Union Budget on 1st February is poised to trigger the usual market turbulence that comes along with the uncertainty in policy decisions by the government. Every year, traders wait for this day and eagerly search for various strategies to capitalize on this volatility. 

However, more often than not, the majority of them end up making losses. The reasons include having no strategy, exhibiting behavioural biases, lacking patience, getting into multiple trades, etc.

To identify what works best during the budget days, we ran an analysis. We scrutinized the past 12 budget days (2014-2023), including interim budgets, to identify some strategies that not only weathered the storm but also emerged as consistent profit-makers.

Understanding Market Volatility

Union Budget announcement days have been very volatile historically, with the movement in Nifty50 ranging between 2-3% on an intraday basis on 10 out of the last 12 instances (2014-2023, including interim budget announcement days). 

To gain on some potential windfall, traders often turn to derivatives, specifically option strategies, to navigate these unpredictable market movements. Our research is focused on two broad approaches – whether to take a directional call or play a neutral strategy during the budget day.

In a directional strategy, the goal is to profit from predicting the market direction (up, down, or sideways).

For example, you can buy calls if you think the market will go up, or buy puts if you think it will go down, or sell covered calls if you expect a sideways movement. These strategies come with higher risk, as your profits depend on correctly predicting the market but you also get higher rewards if your prediction is accurate.

While in case of neutral strategy the goal is to profit from market volatility regardless of the direction.

These strategies involve buying and selling options at different strike prices and expiry dates to create defined risk and capture volatility premiums. These are low risk, as you don’t directly bet on the market direction. Although you get lower rewards compared to directional strategies, but profits are more consistent as you are not reliant on predicting the market direction.

Playing the Volatility Crush

While taking short positions on other days when Nifty 50 shows such high movement will result in massive drawdowns, the Budget day is different.

Directional calls are very risky. Every minute of the Finance Minister’s speech dilly-dallies the index, making it highly uncertain to gauge the final move. 

However, unlike directional calls, where one has to play on delta, neutral strategies are safer and capitalize on volatility crush (vega), a phenomenon observed as the India VIX index that measures the volatility based on NIFTY options, rises in markets leading up to the budget and subsequently crashes during the budget speech.

To test the above hypothesis, we tried various strategies such as shorting Straddle, Strangle, Iron Fly, Iron Condor, Ratio Spreads, Ratio Back Spreads, Butterflies, Batman, Jade Lizard, etc. The strategy is entered at 9:30 am and exited at 3:25 pm with no adjustments in between. 

The strike selection for all the legs is dynamically selected based on the combined premium on the short and the long legs, i.e., the side with a higher premium has lower exposure, and the one with a lower premium has higher exposure, having risk management implicitly built into the process.

The Analysis

The result showed both Short Iron Fly and Short Iron Condor proved profitable maximum times in 11 out of 12 instances in last ten years. The maximum profit per lot earned in Short Iron Fly was in 2018 (₹1,700 per lot), and in Short Iron Condor was in 2022 (₹650 per lot). 2021 was as an outlier event when Nifty 50 moved 4.74%. However, even in such massive movement, the maximum loss was limited to ₹5,300 per lot in Short Iron Fly and ₹3,050 per lot in Short Iron Condor strategies due to strategical hedge placed on Out of Money (OTM) wings, as long positions.

Here’s a snapshot of the strategies under research over the past 12 budget days over last 10 years including the two interim budgets of 2014 and 2019:

As you can see above, while the average P&L of Put Ratio Spread is the maximum, the hit ratio is not high.

Given this is an enter- and- hold strategy, we liked to see a strategy resulting in the highest hit ratios. We see that Short Iron Fly and Short Iron Condor have consistently outshone other strategies although being neutral in their outlook and have proved successful 11 out of 12 times.

Short Iron Fly strategy involves selling a call and a put of ATM (At The Money) strike and hedging it with a call and a put of strike price at some points above and below the ATM respectively. It’s like a short straddle hedged at both sides by going long the options. As can be seen from the table, the maximum profit per lot earned in Short Iron Fly was in 2018 (₹1,700 per lot).

Short Iron Condor strategy involves selling a call and a put of close to ATM strike and hedging it with a call and a put of strike price at some points above and below the ATM respectively. It’s like a short strangle hedged at both sides by going long the options.

For example:

On 1st Feb 2023, for Short Iron Condor strategy, the call and the put sold were 600 points away from the ATM of 17900, that means, shorting a call of 18500 and shorting a put of 17300, as the combined premium was close to ₹600. They were hedged using a call and a put which were further 200 points away, so going long a call at strike 18700 and going long a put at strike 17100, as the combined premium was close to ₹200.

Notably, 2021 stood out as an outlier year, impacting overall performance due to the massive movement of Nifty 50 on the upside (4.74% up).

This also shows no strategy is foolproof and traders need to be vigilant and apply risk management practices without fail.

However, if you took any of these trades, even in such massive movement, the maximum loss was limited to ₹5,300 per lot in Short Iron Fly and ₹3,050 per lot in Short Iron Condor strategies, due to strategical hedge placed on Out of Money (OTM) wings, as long positions.

Adjustments and Risk Management

It’s crucial to be prepared for sudden market movements. General adjustments to neutral strategies involve considering hedges if NIFTY 50 makes a strong move like what happened in 2021. Adjustments can be done by exiting the strategy earlier, closing one leg of multi-leg strategies like iron condor or iron fly, or adding another option to hedge the open positions.

Conclusion

While we present these findings as factual observations, it’s imperative for traders to conduct their own analysis and exercise caution. The market is inherently unpredictable, and risk management remains key. As we approach this budget day, may your strategies be resilient and your trades be prosperous.

Happy trading!

(Note: All the numbers above have been rounded off for better representation)

This article has also been featured on Livemint.

Disclaimer: The above analysis is for educational purpose, please do your own research before trading/investing.