Higher implied volatility amid COVID-19 fear: Use these 3 modifications while ‘writing’ trades

Shubham Agarwal

Options have been compared with insurance policies a lot of times and right so as the instrument has many comparable qualities. Taking this analogy, a bit forward writing or selling Options is similar to selling an insurance policy.

With the receipt of premium, an option writer just like an insurance policy assures the buyer of the policy to pay-up in the case an unforeseen event.

More often than not the unforeseen or unexpected does not happen and the writer pockets the premium. But, sometimes similar to the current situation with the coronavirus (COVID-19) pandemic, these insurance policy writers are in tough times.

Writing Options and covering the Option Buyer is equally difficult as the possibility of any unforeseen, unexpected event increases.  This makes Option Writing a lot riskier.

Just like in 2008, nobody knows when this pandemic will end and there is even less accountable and forecastable in terms of the damage it could do.

In situations like this, liquidity dries up. While premiums are more attractive than ever no one wants to write due to the sheer rise in the probability of loss.

As a result, these three trade modifications could come in to play by option writers.

Reworking the frequency of writing:

The best practice is to reduce the systematic writing practice. More often than not Option writers are used to calendar-based Writing. This means some of them would open short option positions right at the beginning of the month, some five days before and so forth.

Stop that immediately when implied volatility is as high as it is right now. Trade the drops in implied volatility instead of time as in current situation change in implied volatility would impact the premiums more than time.

Resorting to Re-Insurance:

So, the one thing that comes to rescue is the real-world scenario - Re-Insurance. Write Options but with a Known loss meaning Sell an Option but at the same time Buy a farther strike Option at the same time and Sell an Insurance and Buy one as well. Sell a Put and Buy a lower Put or other way around in Calls.

Butterflies:

This would come at a later stage but since we are already a couple of weeks in the turmoil. Fortunately, if we see the implied volatility on its way down.

Use butterfly to gain a maximum of the time value. Sell both Call and Put of the strikes closest to the current underlying level and buy strikes on either side with a distance equal to the premium received.

Example: if we see risk reduction after a spike around 9,800 Sell 10,000 Call & Put. Let us say if we pocket Rs 600 Buy 9,400 Put and 10,600 Call.

But, before using this modification to the Option Writing remember is someone finds the vaccine for COVID-19 we may just reverse in full swing instead of just halting the fall and consolidating.

In a nutshell, what we have discussed are a few techniques that puts implied volatility in the front seat and being vigilant about the drawdowns more important.

The author is CEO & Head of Research at Quantsapp Private 

Disclaimer: The views and investment tips expressed by investment experts on moneycontrol.com are his own and not that of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.