In the seven-month period of August 2014-February 2015, the National Stock Exchange's benchmark Nifty has given a return of about 17 per cent. It was near 7,600 in early August and closed around 8,900 on February 28. A passive buy and hold position from early August would pick up 17 per cent, while a systematic investment plan (SIP) would have yielded eight-nine per cent for the corpus during that period.
Good trend-following systems would have picked up a large part of this return. But the trader would have to the stop-losses well. One issue with trend-following strategies is if there are large draw-downs, the system has to set good trailing stops to avoid profit erosion.
It was not a smooth uptrend. The corrections were significant. There were multiple successive peaks and troughs, with each set running higher. (All the following numbers and dates are rounded off, not exact).
In mid-September, the Nifty hit 8,150-plus (Peak 1) and then it dropped to 7,750 (Trough 1) in mid-October. That was a bull run of 550 points, followed by a retraction of 400 points. Peak 2 was at 8,650 in early December and Trough 2 was 7,960 in mid-December. Uptrend of 900 points, retraction of 700. Peak 3 was 8,950, late January and Trough 3 was 8,525 in early February. Uptrend of 1,000 points, retraction of 425. Peak 4 came at 9,120 in early March after the Nifty ran up to 8,900 on the Budget day. The current correction, or Trough 4, has hit 8,750.
An options trading system could be used to pick up the high volatility, rather than picking up direction. Option traders might just have hoped for a big move in every settlement. Let's say, a "big move" is defined as a five per cent swing in either direction, away from the closing price of settlement day.
A long strangle could be used. This consists of a long call and a long put, with strikes set around five per cent from the money. Each of these would cost roughly 0.5 per cent of the strike price. That is, taken together, these work out to about one per cent of the prevailing index value.
If the Nifty moves enough to strike one of the options, the returns would be anywhere from two per cent to 10-15 per cent or more. The exact return would depend on the extent of the move and the time to expiry when the strangle was struck. Assuming a return ratio of 2:1, such a strategy breaks even if the volatility hits five per cent or more in one out of every two months.
The Nifty moved more than five per cent in five of those seven months. In effect, the return during this period has been close to 3.5:1, implying a profitability of 250 per cent for this strategy. More generally, such a wide options strategy might work during any period of high volatility.
The details of such a system are tricky. What is the ideal distance from money - should long options be taken at five per cent or 7.5 per cent or 10 per cent? The more the distance, the less the chance of the position being struck but the more the returns if it works. In essence, Nassim Nicholas Taleb has made his money and reputation by using this sort of low probability, high return strategy.
The market is trading close to its all-time highs. It could go up, down, or sideways but the volatility is likely to remain high. It seems worth considering a wide strangle strategy.
The author is a technical and equity analyst
