Going by the broader market perspective, the definition of high IV and low IV changes depending upon the market scenario.
Implied volatility at the trading terminal is calculated via a in-built software, which uses the Black Scholes formula, says Siddharth Bhamre of Angel Broking. It does not even require you to punch in any parameters. The parameters which influence option prices are implied volatility, strike price, spot price, time left for expiration and interest rates and whether there are any dividends or not. All the parameters are automatically taken in that calculator from the system.
Most people don’t understand implied volatility. For them, if IV is high then they sell the option and if IV is low, they buy the option. But who defines what is high and who defines what is low, asks Bhamre. He says, for stocks, according to their historical volatility, how volatile they have been, implied volatility would be different. For low beta stocks, IVs would be less and they would have their own range of high and low, he says. Going by the broader market perspective, the definition of high IV and low IV changes depending upon the market scenario.
According to him, it is not just important to understand what is IV and how it impacts option premium, it is also important to understand the historical trend how IVs have moved.
He says, an investor should hedge his portfolio when valuations are high. Hedging is not about protecting you from loss, one should think about hedging as a part of hedging your profit.
Below is the verbatim transcript of Siddharth Bhamre’s interview on CNBC-TV18
Q: We have spoken about implied volatility. How do you read implied volatility when you are at a trading terminal?
A: It depends on the kind of platform you have, the trading platform. Generally most of the participants have this platform called ODIN. You need not calculate implied volatility (IV), there is an in-built software which uses Black Schole formula to calculate implied volatility. So you need not have that calculation at the back of your mind.
You just have to click on the implied volatility button over there. The parameters which influence option prices are implied volatility, your strike price, spot price, time left for expiration and interest rates and whether there are any dividends or not. All the parameters are automatically taken in that calculator from the system.
So you need not punch in any parameters, you just have to click on the implied volatility button and then implied volatility of that particular option of that particular strike of one particular expiry would pop in front of you. That is how it is seen on the screen.
Q: Does that mean that the implied volatility for different strike prices even if they are on the same expiration is different even if it is a particular stock, let us say a banking stock and State Bank of India (SBI), would the implied volatility be different for different strike prices on any given transaction or trading day?
A: Yes, it is quite likely that they might be different. Sometimes it is the variation or the change between the two IVs of different strike price, may be less, sometimes it would be more. It is simple to understand that in case SBI today is trading somewhere around Rs 1,800, there would be different kind of people who would be interested in buying 2,000 Call option and there would be different kind of people having different mindsets, having different management in place who would be willing to buy 1,800 Call option.
So the price they are willing to pay would be different. Apart from ceteris paribus that all other things remaining constant so that influences. Any change in premium impacts IV because the rest of the thing doesn’t change on that particular instance. So yes, it is quite possible that for any particular stock, different strike prices of Calls or different strike prices of Puts may have different IVs. That is the reason whenever you want to see the IV of a Call option, you have to take weighted average of all strike prices. Give more weightage to at-the-money strike, give less weightage to out-of-money strike.
Q: For a Put option or a Call option which you are deciding whether you want to go ahead and purchase it, how would you read the implied volatility and what are the aspects that you would consider?
A: First thing people are not aware about implied volatility. But what they understand is if it is high then I sell the option and if the IV is low, I buy the option. But who defines what is high and who defines what is low? Is this high or low implied volatility same for all underlyings? No. For stocks, according to their historical volatility, how volatile they are, implied volatility would be different.
For low beta stocks, IVs would be less and they would have their own range of high and low. Case in point, National Thermal Power Corporation (NTPC) is a less volatile stock so you would have probably 21-24 IV as high IV for it and 16-17 IV as low IV for it. DLF is in highly volatile stock. So probably for DLF, a 40 IV is high IV and 22-23 IV is low IV. So depending upon the volatility of stock, IVs change.
Second important point, if I take from broader market perspective, depending upon what kind of market scenario you are into, the definition of high IV and low IV changes.
Q: So it is a relative value?
A: Yes. In a bull market IV of 16-15 will be considered as low and IV of 21-24 would be considered as high. So there is a ban. In a bear market a 21-22 IV is a low IV and 38-40 IV is a high IV. In a range bound market, a 12-13 IV is low IV and 20-21 IV is high IV. Today what I consider as low IV in a bull market or today what I consider as a low IV in a bear market can be a high IV in a bull market. So, you need to decide in which market scenario you are and then accordingly decide whether this is high IV or low IV. So it is not just important to understand what is IV and how does it impact option premium, it is also important to understand the historical trend how IVs have moved.
Q: How often does the IV dictate your opinion of what option you are going to choose, supposing you are bullish on the markets and have made a strategy according to it but the implied volatility seems to suggest a case scenario which is opposite of that. So you are setting out to buy Call options but would you change your strategy and go for a Put instead, how does implied volatility dictate your choice or your strategy?
A: Every single time if I do trade in option, implied volatility dictates my terms and conditions at which instrument I am going to use. First thing, you need to have a view. So that is the base thing. Then suppose I have a bullish view on the market and say IVs are high I would not buy a Call option. I would probably form some ratio spreads, I would probably form bull spread or if slightly I can take more risk, I will sell the Put option but I will never buy a Call option because if my view is positive and if it goes right, the market would go up.
In a rising market, IVs come down. So many a times, people have seen that the underlying goes up, they have bought Call option, but their Call premiums are not going up. Why? Because they are buying Calls when their IV is high. At that point of time, what one has to do is sell Put options, sell at-the-money or out-of-money Put options because if your view is going right, the market is going up, the value of Put will anyways decrease but the reduction in IV would make value of Put decrease with much faster pace. So every time, I decide that I want to do an option trade. The first thing which I look is what is the IV of an option.
Q: How do I know when to hedge my portfolio and to what extent because the amount of risk is never very clear to the investor on the street?
A: It depends on what kind of portfolio you have. Broadly, we can say there are two kind of people, investors and traders. Investors are an important part of the market. We need to club a lot of other things rather than just F&O market for hedging. Take a classic example, which is still fresh in everybody’s mind, what happened in 2007 and 2008.
In 2007 fag end, valuations of the market were like 22-23 PE, October 2008, valuations of market were around 9-10 PE, nobody was talking about hedging in December 2007, everybody was talking about hedging in October 2008.
It should have been completely opposite actually. As an investor you should hedge your portfolio when valuations are high because that is the time you need hedging. Hedging is not about protecting you from loss, first you should think about hedging as a part of hedging your profit.
Now in October 2008, when valuations were already so low there was no need for hedging or you could have done a little bit of hedging. Maximum hedging was required when valuations were high. So from the investor angle he needs to see his portfolio, he needs to club the fundamentals that how my stocks are placed from valuation perspective. If he feels that valuations are very high and we hear so many times that it is liquidity which is driving the market that is a time when he should be very careful and hedge the portfolio. At the bottom level I don’t think hedging is required. But yes, at that time he can do hedging with Options rather than with Futures.
At the high valuation segment he should do hedging with Futures rather than Options because Options would be expensive then. For traders, it is not about valuations because they change their positions almost on a daily basis, for them hedging is more of a risk management thing. Again here the emphasis should be given more to what I am doing to protect my profits, there is a tendency and I am sure 90 percent of people do this in this market that you don’t ride your profits, but you suffer your losses to a large extent, if I am buying a Rs 100 stock, I will move out at Rs 105, but if it is moving down I will wait till Rs 60-70.
So first thing, risk management has to be in place in terms of hedging then what is to be done for a hedging of a trading portfolio, suppose I am State Bank of India (SBI) long, say I am ICICI long, I am ITC short, I am Reliance long and there are a few volatile stocks which I am say again long. So basically I have a long trading portfolio, I need to calculate the beta of it first. What is the beta and say beta is one for simplicity of calculation then for my trading portfolio atleast 50 percent of my portfolio I should be Nifty short or say broader index short.
I should be Sensex short or Nifty short that is one ways of hedging my portfolio. The second way of hedging is buying Options, I should buy Put Options. If my portfolio has gone up by say 15 percent for an investor, for a trader say my portfolio has gone up by five percent I should keep adding Put Options, provided IVs are low and if IVs are high I should start selling Call Options, that is how hedging should be done for the portfolios.
Q: A lot of investors have very vast portfolios. The entire exercise of calculating beta and then deciding whether it is high-beta or low-beta could be time consuming. Is it possible, especially given the example of 2007-08 when the markets were euphoric that you look at the PE of the market or your benchmark index and if that seems over the top to you or if that seems highly valued to you then you can take a hedging position or do you think that does not work, you need to know the temperament of the portfolio first.
A: It is important to know what is your portfolio. I have learned a lot about markets in the last few years, especially in 2007-08 that it is not just valuations. Liquidity also is very important to understand which drives the market. So if we feel that valuations are high a general person would just sell his portfolio rather than hedge it. Why he should hedge? If valuations are high let us sell the portfolio and then we buy at lower levels. We have seen stocks like Hindustan Unilever (HUL) and ITC, people have been talking about their valuations being high, but these stocks are making new 52-week highs day in and day out, why, because liquidity is chasing defensives. So it is not just important to see valuations. You have to see where the liquidity is moving and accordingly you hedge. So that is what people should do.
They should find beta of their portfolio, they should find the composition of their portfolio and ride on the profits by hedging it rather than now and then booking profits and then regretting it, okay I have booked profits but my stock has gone up.
Q: What is the number of stocks than you think is optimal for a lay investor to keep? He should not have more than 10-15 stocks, so that he can manage his beta, that is the volatility and then take positions accordingly.
A: Generally if you do portfolio management, ideally if you see any good performing mutual fund you will not see more than 25-30 stocks. But then a mutual fund manager has a good team who can take care of a lot of other sectors. So he can manage 25-30, some of these schemes have 100 stocks also. So they are doing their optimal utilisation by deploying a lot of resources, but as an individual I do not have any resources, I just have some platforms through which I can do some research.
One should not have beyond 10-15 stocks in their portfolio. First thing I have limited capital. I am not as big as mutual funds or hedge funds, so I cannot diversify it that much, not just in terms of money, but also in terms of mindshare. So I need to have very less amount of shares in terms of number of shares. So 10-15 is good enough.
You need to diversify also. We are talking here about high-beta or volatile space. There is a notion that volatility means the stock is not fundamentally good. Many a times what happens is you have less liquidity in the counter. When I am talking about less liquidity I am not talking about illiquid stocks, I am talking about relative to large cap there is less liquidity in midcaps and that is why they are more volatile. So there are a lot of names whether it is capital goods or the banking space where stock moves are volatile, but fundamentally they are good companies. So I need to have those kind of stocks in my portfolio. Beyond 10-15, no.
Also one has to do the exercise on correlation between these volatile stocks to large cap stocks. It becomes easier to hedge, because large cap stocks and index have good correlation, but many a times we have seen that there are some stocks which move in completely opposite or wayward direction within the sector. So those stocks should be avoided. So the hedging part becomes easier. How you do hedging of this? Again you have to come to the index, because these liquid midcap names may not have very strong liquidity in option segment.
Our market has this drawback that out of so many stocks in F&O segment you just have 10-15 stocks where you have good liquidity in option segment of the individual stock. So to do any kind of hedging for your portfolio you have to rely more on index. So there should be a good correlation between these stocks and index for you to do better hedging.
Q: In a volatile market how different is it to manage a high-beta portfolio versus managing a low-beta portfolio?
A: Due to any event if volatility of the market increases, the impact of that would be on both the portfolios. Your low-beta portfolio would increase its volatility a bit and your high beta portfolio will also increase its volatility. So there may not be a separate strategy as such for two different portfolios, but universal approach can be adopted. How do I hedge my portfolio when volatility is increasing? First thing it is difficult to predict that when volatility is going to increase, so you have to be prepared. Generally, what people do is they try to hedge portfolios or make some strategies just when they come to know about the event, case in point Infosys results. If you have noticed, always before results implied volatility (IV) goes up significantly. This quarterly result the IV had gone to 100 percent, that was way too high for them and after results whether results are good or bad, they crack.
Generally people tend to make the mistake of hedging just a day before Infosys result or probably a couple of days when IVs have completely gone up. So smart traders who know that how IV of this stock moves before result, they go long options, probably one-one and half week before the results, because they know there would be a lot of people who do not know how IV function, they will start coming and buying these options. So when you want to hedge, you should hedge much before the event rather than just at the event. This would make sure that your cost of hedging comes down. Your Put or Calls one and half week before would be far cheaper than what they would be one day before the event.
Q: Give us the other side of it which is that usually post results is when everybody reacts to the situation in which case carrying on the example of Infosys what would you do?
A: Post result stories where IVs crash and whether stock has gone up or down is secondary. What is important is when people wake up just before the result, a day or two before and they really want to hedge their portfolio you need to basically have some idea that what is the expectation of the market in terms of results. If you are expecting an inline performance and you are seeing very high IVs no need to hedge, because your cost of hedging will be way too high, or you can hedge it by selling options, say I am long Infosys. Infosys is trading at Rs 2,500 and I am expecting results to be in line with the market and there is huge volatility. So what I should do is I should sell deep Out of The Money (OTM) Call options. If I am not an Infosys shareholder, but intend to buy Infosys, if it falls because of bad numbers then rather than doing something else what I should do is I should sell deep OTM Put option which is expensive. I sell Rs 2,200 Put option and I get Rs 70-80 premium for that.
So even if Infosys does not fall, I pocket in that premium and if Infosys falls to Rs 2,200 because of bad numbers I made a wise decision of not buying it before the results. So again in every aspect of your hedging apart from your view which is the base, the second pillar of that is IV, because that determines what instrument you have to use for hedging and whether you have to be on the buy side or the sell side of that instrument.
Q: Give us an example of how will you manage your portfolio in a market which is not volatile, which is going through either a sideways situation or seeing very low volatility?
A: Suppose the market is in a range. Sensex is in a range of 1,000-1,500 points and markets are not going anywhere and large cap stocks are also doing the same, that time as we mentioned before IVs generally reduce in a range bound market. Then also you get that IV of 20 as high and you also get IV of 12 or 13 as low. You can adopt exactly the same strategy, but rather than waiting for 30 IVs or 40 IVs to sell Call or Put you can sell it at 18 to 20 IVs also. So strategy remains same.
Only thing is your IVs change which confuse people a lot because in a bear market or in a bull market which we consider at 24 or 30 IV as high IV you do not see such high IVs in a range bound market. So you have to reduce your high IV zone. You have to reduce your low IV zone also and trade accordingly. So there is no separate strategy as such, but the levels of IVs change.
Q: An important aspect of taking a position is knowing when to square if off, when to leave your portfolio unhedged. Since 2007-08, we have had highly volatile markets. The gains that we saw in 2012 were also unexpected. So therefore when do I decide that this time I can leave my portfolio without any hedged bets?
A: An event has two outcomes. Either of two outcomes can happen, a good outcome which is good for your portfolio, a bad outcome which is bad for your portfolio. If it is a good outcome you can just simply remove your hedging positions. One thing which we need to take care of is what were the positions before the event? This quarterly result if you see there was so much of hedging done for Infosys, but there was not much position built up for Reliance. Reliance numbers were not very great. Infosys numbers were good. Despite Infosys stock going up we see option premium coming down. Reliance stock went down. Option premium of Put options increased, why because there was not much hedging done.
So two things which we have to take care of when the event is done, what were the positions before the event, can you ride more by way of short covering which other people have formed or if there are no positions then I also need not keep my positions hedged, I can ride the wave. Second thing that if an event is bad which is bad for my portfolio irrespective of IVs are high or low and you have hedged it at the right time, continue to hedge your portfolio. Do not remove your bets. So it is the outcome and again the IVs and positions which have been formed determine whether I should continue my hedge portfolio or I should let it be unhedged now.
Q: So IV is a key indicator which can either change your opinion of the strategy you have or it can reinforce, so rather than listening to any market opinion, IV is what you would depend on?
A: IV is the biggest indicator which one can have. IV talks loudly to you that what you should do. If it is high be aware of that underlying. If it is low check the view. If you are positive, go and latch it up.
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