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Traders work out strategies for budget rally

This article was posted on Jun 26, 2009 and is filed under Market Outlook

MUMBAI: Wealthy stock traders — those who missed out the post-election result rally as well as the handful who tasted success — are trying to ensure that they have a winning formula ready to cash in on the post-Budget swing in stock prices. These players are creating trading combinations in equity options that will help them capture extreme movements on either side.

Two of the most commonly used options trading strategies by these traders are strangles and straddles, which have been put to good use by foreign institutions. Tempted by the low risk associated with these strategies, more and more wealthy traders are taking to them.

The participation of retail investors in such strategies is minuscule, as they seek trading strategies to bet on the market direction rather than implied volatilities (IVs) — the expected volatility in an index or share price — a key aspect of pricing of options premium (when IVs rise, premiums rise, and the converse also holds true).Derivatives analysts have been divided over the use of these options trading strategies to bet on IVs.

Some, including brokerage Sharekhan, are recommending buying straddles, which means a trader would bet on a jump in IV ahead of the Budget. In a straddle, the trader buys a call and put option each of same strike and expiry. Abhinay Jain, a derivatives analyst at Sharekhan, recommends buying one Nifty 4300 call and put option each of July expiry, prior to the Budget.

But a section of analysts, including Geojit Financial Services, feels buying straddles would not be wise at this juncture, as option premiums are expensive. Higher premiums offer very little scope for any sharp upsides. Geojit is recommending buying strangles, which is again betting that there will be a jump in IVs ahead of the Budget. But, in this strategy, a trader buys an out-of-the-money call and put option. Geojit’s Alex Mathews said if the index is at 4300, the trader can buy a call option at 4700 and a put option at 4000.

If the premium charged for the call and put option is Rs 50 each, then the trader will gain only if the index crosses 3900 on the downside and 4800 on the upside. But, analysts advise squaring up the strategies just before the Budget. “Traders need to buy these strategies around five days before the Budget and square it off one hour before the Budget starts, as IVs will start dipping just after the event,” said Geojit Financial Services’ derivatives head, Alex Mathews.As uncertainty recedes after the event, IVs dip. Analysts said the main risk to these strategies is if IVs do not rise ahead of the Budget, traders lose out on the premiums.

source: Economictimes

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