Structured products or strategy that profit from lower-than-expected equity volatility are most popular in India. The strategy here is to periodically sell one-month, 10 percent out-of-the money Nifty50 Index put and call options.
Implied volatility — a measure of future uncertainty — mostly trades at a premium to the underlying historical volatility and the idea is to capture this difference in volatility as the option is priced on implied volatility, while the final settlement on the options depends on the path the underlying takes — which is measured by its realized volatility.
Nifty Implied and Historical Volatility Spread
A call contract gives the holder the option, but not the obligation, to buy a security at a pre-determined level or price, while a put contract gives the holder the option, but not the obligation, to sell a security at a pre-determined level or price.
Nifty Distribution: A Eight Percent Chance of a+/- 10% Monthly Return
The 50-stock index follows a normal distribution, but the actual occurrences of return and its magnitude — both kurtosis and skewness — differ from the theoretical expected occurrences.
Thus, selling a 10 percent out-of-the money strangle seems effective given this backdrop.
Backtesting & Assumptions
To test this concept, I performed a quick backtest using Bloomberg’s option strategy backtesting tool alongside (above) volatility charts to identify the effectiveness of this strategies from Feb. 2016 to Feb. 2019 with the following assumptions:
- Backtesting assumes zero friction and one lot of 10 percent out-of-the money call and put options were sold.
- Trade was entered in the near month contract on the day of the expiration of the current month contract.
- No adjustment was done during month and the trade was rolled over to the next month contract expiration.
- Trade was left untouched and all statistics were recorded between entry and expiry levels.
Equity Curve of the Backtested Result
The strategy that sold a 10 percent out-of-the money call and put option shows stable but significant profits over three years. Of the total 36 trades, only one resulted in a loss during March 2016 and the strategy had a hit rate of 97 percent during this period.
Thus, selling volatility with a two standard deviation range increases the probability of profit as there is only 5 percent chance of a risk.
If you find value in what I am doing, buy me a coffee https://www.buymeacoffee.com/kannansi
