FIIs Count on Higher Risks in August to Make a Killing

Buy Nifty option combinations to bet on higher IVs as volatility index drops to its lowest since '11

Derivative desks of savvy foreign institutions are betting on an increase in stock market risks in August. They are forming trading strategies in Nifty options of August series aimed at benefitting from a possible rise in implied volatilities, which is the traders' perception about near-term market risks based on options premiums. Implied volatility (IV) is a key component of options premium pricing. 

Foreign institutions are buying combinations of Nifty options to bet on higher IVs or premiums as the volatility index (VIX), which represents a 30-day view on volatility in the Nifty, dropped recently to its lowest since 2011. VIX, which usually hovers around 20-22, fell to 15.42 on July 27, which is its lowest since January 2011. On Wednesday, the India VIX moved up 2% to 16.77. "FIIs are very much on the buying side in options, which is also seen in their trading data," said the derivatives head of an institutional broker in Mumbai. "Such trades involve buying options within 100 points of the Nifty's current levels. Some are betting that the volatility in markets will increase this month due to events in Europe," the person said. 
Foreign institutional investors have been at the fore of this strategy, buying volatility using Nifty options. FIIs have net bought around . 12,180 crore worth of index options in July, and . 790 crore worth of contracts so far in August. 
Volatility trading involves buying or selling a call and a put option on indices like Nifty. A common strategy betting on a rise in implied volatility is to buy put and call options, such as those at the 5200 strike price, and eventually making profits when Nifty moves sharply on either side. Volatility traders are not concerned about the direction of the stock or index, but bet on sharp movements on either sides and profit from the uncertainty. 
Some domestic brokers such as Nirmal Bang have recommended clients to buy volatility, which said that 15-15.5 is a historic support level for the India VIX. 
"One can expect an increase in volatility from current support clusters. The ideal strategy would be to go long on volatility and expect the VIX index to go towards the 22-24 levels in the near future, which is the falling resistance line drawn from the highs of November 2011," the broker said in a note to clients. 
The view was echoed by technical analysts, who said that charts indicate that a rise in India VIX is highly likely. 
"At these levels of VIX, there is a nearly 80% probability that volatility will move higher, while above 19-19.5 we could see short positions coming back," said Shubham Agrawal, AVP and senior technical analyst at Motilal Oswal Securities. "We see at the most 14-14.5 on the downside, which is a small target," he said. 
The counterparties to these bets on higher IVs have been retail investors, who have been selling options over the past month. Perceived as a sureshot way to earn in a flat market, option selling is extremely risky. Any sharp move in the market can lead to infinite losses. "Nearly all retail branch managers say this: clients are blindly writing options, expecting the market to be in a range. Such heavy selling also explains why IVs have become so low," said Siddarth Bhamre, head — equity derivatives at Angel Broking. 
Analysts said that option sellers have a view that the market may not move more than 5% on both sides from here. Some are even betting on the September contract series. 
"Option sellers are assuming a broad range in the Nifty of 5000-5300 and selling out-of-the money options beyond this range,"said Amit Gupta, head — derivatives at ICICI Direct. 
For example, traders are selling 4900 and 5000 put options, and 5400 and 5500 call options. 
"Volatility may spurt in this month and lead to a 2-3% change in the Nifty… but selling options is a safe bet as long as markets move within the broad range. The selling is in both August and September series," he said. 
nihar.gokhale@timesgroup.com