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How does one adapt to low options volatility? Shubham Agarwal explains

In times of low volatility, a little bit of tweaking would help avoid undue losses.

November 12, 2022 / 03:06 PM IST

India VIX is almost at a year-low. In a way, that is good for the market, as India VIX has a negative correlation with Nifty. In general, Lower India VIX = Lower Risk of Falling. India VIX is also called the risk index or the fear index.

However, there are a few more things that accompany falling India VIX. First, India VIX is a proxy for Nifty Options Implied Volatility. An integral part, and probably the only subjective factor, in Options premium calculations, is volatility. The rest of the four factors used in the calculation of options premium, viz. Underlying Price, Strike Price, Time to Expiry and Risk-Free Rate of Interest, do not have any different answer.

Given the rest of the four known factors and the premium traded in the market, the volatility figure back-calculated is called Implied Volatility (IV). Now, since the rest of the four factors are already known, any significant change in premium without any significant change in the underlying price and time to expiry can be attributed to the change in IV.

Higher premiums are attributed to higher IV and lower premiums to lower IV. So, in this sense, the falling India VIX, led by falling overall Nifty Options IV, has lowered the Options Premiums as well.

Now, India VIX or IV, by nature, is mean reverting. In other words, it moves in a range. It wouldn’t keep falling perpetually or rising perpetually. So, a certain set of Alterations in trading options is required to adjust to the fact that what has gone down, could bounce back, raising options premiums without any help from directional movements.

Alteration #1

Stick to buying options strategy for short-term trades

Since options IV is lower it is not discounting any big move, and thereby keeping the premium value lower. Any directional move should be traded with a buy position in Options. This would help in two ways. One, in case of a favourable move, it would raise the prices of options. Second, if the expectation of movement goes up and IV rises, we would gain as rising IV will push up the premiums.

Alteration #2

Avoid option strategies with net sell options

Options are often used in combinations, often with more sell quantity than buy. This is done to take advantage of low directional momentum. However, these strategies should not be resorted to in a low volatility environment.

The simple reason for this is that extremely low volatility (in this case IV) cannot sustain for a long time. So, if we are net sellers of options and the IV were to mean revert and go higher from the lower extreme, we would tend to make a loss.

This needs to be especially taken care of by regular sellers of options (Far off call & put sellers).

Alteration #3

Add a Hedge

It is more likely that low IV or low India VIX would be seen mostly during a bullish trend. With its negative correlation to Nifty, if India VIX rises, led by a rise in IV, then this could be accompanied with a fall in the index.

So, as a third alteration for one’s trading portfolio, there should be a hedge protecting against any such a violent down-moves.

Thus, in times of low volatility, a little bit of tweaking would help avoid undue losses.

Disclaimer: The views and investment tips expressed by investment experts on Moneycontrol.com are their own and not those of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.
Shubham Agarwal is a CEO & Head of Research at Quantsapp Pvt. Ltd. He has been into many major kinds of market research and has been a programmer himself in Tens of programming languages. Earlier to the current position, Shubham has served for Motilal Oswal as Head of Quantitative, Technical & Derivatives Research and as a Technical Analyst at JM Financial.
first published: Nov 12, 2022 03:06 pm