Hedging strategies for the Budget

The run-up to this Budget is conforming to the traditional technical pattern, with optimism, greater volumes and higher volatility. The Budget session itself tends to be extremely volatile. It is followed by either a big sell-off or a sustained bull run. The market might swing 125-150 points in single sessions.

Most traders take directional views. This can be highly lucrative or can result in huge losses. Option traders can use the flexibility afforded by these instruments to limit losses while setting themselves up for gains.

A few indicative hedging strategies are outlined. The premiums (based on March 13 intra-day prices) will change by the time you read this but the strategies will remain valid. You can plug in prevailing premiums and calculate the possible payoffs and costs.

When the trader expects a big move but is unsure of direction, he can take a strangle. This is a long call and a long put “strangling” the spot price. For example, with the spot Nifty at 5,430, the trader could buy a long 5,400p (current premium 89) and a long 5,500c (93).

Expectations are bullish. The call, which is further from money, is priced higher. This position costs 182 at current prices. It breaks even at 5,582, or 5,218. A similar strategy can be employed further from money.

For example, a long 5,200p (37) and a long 5,600c (54), costs less with breakevens at 5,691 and 5,109. The cost can be further reduced with a short 5,100p (23) and a short 5,700c (29), creating breakevens at 5,161 and 5,639. This position pays a theoretical maximum of 58 if either 5,100, or 5,700 is struck.

Is the market likely to swing that much before settlement? Perhaps. More importantly every big swing increases premiums on one set of positions and reduce premiums on the other. A smart trader can time his entries and exits to try and make profits on both sides.

If you don’t think the market will swing so much, consider butterfly spreads. For example, if you’re mildly bullish, a long call butterfly of long 5,500c (93), two short 5,600c (2x54) and a long 5,700c (29) is possible. This costs 14 and it pays a maximum of 86. The breakevens are at 5,514 and 5,686. The maximum return accrues if the Nifty hits 5,600. Above 5,600, returns decline.

Similarly, a long 5,400p (89), two short 5,300p (2x58) and a long 5,200p (37) costs 10. It pays a maximum return of 90 at 5,300 with breakevens at 5,390 and 5,210.

A trader can take butterflies, if he’s confident of exiting close to the ideal price. These are directional but losses are minimised and the return-risk ratios can be very high.

The author is an equity and technical analyst