Use a combination of futures and options in index derivatives for best results.
Poker is legally classified in most jurisdictions as a game of chance, which it is blatantly not. Skilled players will consistently generate winnings by applying the right strategy. Every serious poker-player (and Indians who prefer 3-card variants) both dreads and welcomes one situation.
This is when you have a really good hand and somebody else also has a really good hand. It is correct on such occasions to stay in the bidding as long as you can afford to. One player will end up a massive winner while the other is wiped out. A single swing hand of this type can generate a huge pot.
What happened in Parliament this week and the accompanying stock market moves are comparable. The UPA and NDA both bid as high as they could afford. The UPA won and the spate of expulsions in opposition parties suggests losses were quite heavy.
The vote of confidence is a one-off, a type of bet that occurs comparatively rarely. You need special strategies to handle this because you know that there may be a 10 per cent swing but you cannot call the direction with any confidence. Given the political context, similar scenarios could arise several times over the next 12 months. So it is pertinent to review the possible ways in which it can be handled.
First of all, it helps to shelve your political sympathies if any, and your macro-economic take on the fallout from such events. When you trade such situations, you are betting on something as neutral as a coin-toss. Put your emotions aside and consider long-term implications only after the outcome.
That should help you focus on something the vast majority of traders forget. It is silly to stake your entire fortune on a coin-toss. Such decisions make for good cinema and literature; they make for very bad financial planning. Hedge and keep margin in hand.
Second, forget about ancillary stocks when trading such events. Focus solely on index derivatives. Sure, a few stocks will be high-beta and a few negative-beta. But the overwhelming majority will move with the market on such occasions. It is not worth making secondary and tertiary calculations on singular events. The need of the hour is to trade only the most liquid contracts and that means index derivatives.
One possibility is straddles and strangles. These option positions gain on wide movements. The problem is that these are often very expensive and sometimes, there is insufficient liquidity far from money to cut off the position.
In practice, given the liquidity constraints of the Indian market, a combination of futures and option spreads seems to give the best return to risk ratios in such situations. There is one caveat. The futures position needs to be stopped, albeit with a wide stop.
Here’s how the optimal strategy seems to work. Take a long or short Nifty future in the direction that you believe the market will move. Keep a wide stop (2 per cent away) on the future. Take an opposed option spread – with a long future, take a bear spread and vice-versa.
Your costs will be considerable – margin enough to cover the stop loss on the future plus the cost of the option spread. However, with such a position you are guaranteed a positive return if there is a wide swing.
Illustratively, on Friday July 18, you could have taken either a short or long future at 4,077 with a stop about 75 points away. You could then have added a bull spread of long 4,100c (premium 127) and short 4,300c (46) to the short future. Or, you could have added a bear spread of long 4,100p (151) and short 3,900p (81) to the long future.
In the event, both combinations were profitable money. The short future+ bull spread combo made much less money than the long future +bear spread but it did gain. If the UPA had fallen, the market would have crashed and the opposite situation would have prevailed.
Obviously variations on this strategy depend on the prevailing premium and the volatility when such an event arises. However this seems about the most practical way to handle such situations safely.
Most traders were instead either naked long or short and that led to frantic short-covering, which in turn, gave extra momentum to the bullishness.
