Investors look to ride wild swings, post-elections

SENSEX DOWN 138 POINTS

Implied Volatility Jumps To Over 60 On May 12 From 28.18 On March 25

 WITH market direction, post-election results, becoming a tough call, savvy investors are sticking to trading strategies based on volatility. These investors have adopted strategies in equity options, assuming higher volatility in May around the time of government formation and lower volatility in the June series, once the government is formed.
    Hopes that the new government may not need the support of Left parties, has led to these investors creating short positions in volatility through June options contracts.
    Implied volatility — a reflection of market's expectations about future volatility — usually shoots up, prior to the outcome of a key event, such as a election results, or when the market appears overbought. It falls after a massive sell-off, or when the consensus is that the market is oversold. The Sensex, which ended at 12019.65, down 138.38 points, or 1.14% on Wednesday, has been gyrating in the 11700-12200 range in the last week or so, underscoring the nervous mood.
    NSE has a volatility index, VIX, but is not tradable unlike in overseas markets. As a result, investors use options to bet on the direction of volatility by creating combinations of options such as straddles and strangles. So, when an investor buys a straddle, where he buys a call and a put option of the same index, or stock of the same strike price and expiry, he expects the volatility to rise.
    "Foreign investors have gone long on straddles and strangles in the May series in recent weeks, causing implied volatility to shoot up," said a derivatives head at an institutional broking house.
    The implied volatility has jumped to over 60 on May 12 from the year's low of 28.18 on March 25, helping volatility traders make a killing. Given the heightening uncertainty over the general elections results, analysts are not sure where volatility would peak. During the last general elections in 2004, implied volatility shot up to 65-70.
    "Implied volatility usually peaks just before the outcome of an event and drops right after it," said Alex Mathews, technical and derivatives research head at Geojit Financial Services.
    Higher implied volatility means options have become relatively expensive, as expectations of a rise in volatility gets priced into options. Just like experienced investors usually create short positions on stocks that are considered expensive, savvy derivative traders go short on volatility by selling or writing options, when they feel that volatility is peaking. "We expect implied volatility to drop on Monday itself, even if the election results are negative for the market," Mathews added.
    nishanth.vasudevan@timesgroup.com 

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