The Budget sounds like a complex event with hundreds of different expectations on the Street regarding economic or regulatory changes.
Well, some of the expectations are indeed positive while others are negative, but what does it sum up to?
As a trader or an investor, all we want to know is how much points of impact in Nifty does that comes to. Can we assign a simple number to this in terms of Nifty levels?
You might be thinking how is this even possible? But as they say — prices are the mirror of all market expectations.
We will learn a simple technique to use prices to gauge the market expectation.
A trade exists only when your expectation is different than what the market expects. So, to start with, let’s first decode the expectation.
Decoding Market’s Expected Range:
The market expected range is +(-) 3.7 percent. Here is how we calculate it. The magic formula is to add the price of ‘At The Money’ Calls & Puts. The ATM Strike (11050) CE is quoting at 208 and PE at 200.
Adding them both up gives us the combined premium of 408 points. This up and down from the strike is what the market expects the range to be i.e. 408 / 11050 = 3.7%.
As expectations change, the combined premium will keep changing and in a very short term theta decay should be minimal and the one that dominates is volatility in the option pricing.
If your expectation does not match the market; there exists a trade.
If you expect a wider range of movement:
If you expect Nifty to react more than 408 points i.e. beyond 10642 – 11458 a trade to get into would be by simply buying the ATM Calls & Puts of the same strike and expiry.
In the technical jargon, you are buying volatility. This strategy is known as Long Straddle which is a strategy to be deployed if you are sure of a large movement but not sure of the direction.
Unlike Futures; options can provide the beauty of benefitting from a movement either ways and Long Straddle is one of them.
If you expect a narrower range:
For a forecast where you believe that the Nifty may not react as much to the event of budget and may trade in narrower range a simple strategy to trade this would be selling the ATM Calls and Puts with same strike and expiry for a combined premium of 408 points and if the realized volatility remains low the prices of these options should fall sharp post-event.
The strategy is known as Short Straddle. As the trade is inverse, this is a trade for short volatility. Please note: As you are selling options the risk stands unlimited and a strong risk management is a key to managing these strategies.moneycontrol