India Volatile Index (VIX), as we know, is the risk index of Nifty options. It defines the volatility expected in option premiums. There are two characteristics of the expected volatility, as indicated by India VIX, that we should keep in mind at all times:
1. Lower India VIX means lower premium (for the same expiry and same strike price)
2. India VIX is more or less range-bound
We are going through a period of low India VIX for a while now. In fact, the index is at one of its lowest points in three years. With the lowering of India VIX, option writers keep getting lower and lower premiums and the return on investment for option writers keeps going down.
Another characteristic of India VIX is that it is range bound. In range-bound movements what goes down comes back up as well. The India VIX and option premiums move in the same direction.
If from these low levels India VIX were to move up, it will also bring the option premiums up. For an option writer, rising premiums hurt.
In a nutshell, we are dealing with two problems:
1. Lower returns on investments
2. Potential rise in options premium due to rise in India VIX
The solution to both these problems is credit spreads.
What are credit spreads?
Credit spreads are nothing but an extension of option writing. In option writing, we sell a call or a put option. In credit spreads, we buy a relatively higher strike call option or a relatively lower strike put option to the call or put option sold originally.
What are the differences between option writing with just a call or put option and option writing with credit spreads?
Credit spreads have a sell option position along with a buy option position in the same expiry and the same type (Call/Put) option because of which the maximum loss is always limited. This helps in two ways.
1. Due to a limited loss/profit of credit spreads, the margin collected by the exchange on the position is much lower than a single call or put writing margin. Yes, there is a cost to this strategy of buy Option position. However, the drop in margin after buying this option is proportionally much higher.
So, this would solve the first problem of lower returns on investments by lowering the capital requirement proportionately more than the reduction in premium we receive (sell premium vs sell– buy premium).
2. In case the India VIX rises, there will be an increase in the expected risk. This generally means bigger movements and fatter premiums. Since we are doing a spread (Buy + Sell), the majority of India VIX rise-related losses in the sell option will get compensated by the buy option position.
Thus, when India VIX is trading very low and option writing is unattractive, turn to credit spreads.
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