₹ 71,962. This is the amount Short Straddle Strategy could make in three months if one is willing to engage a capital of ₹ 7,00,000. Seventy thousand rupees in three months on seven lakhs makes a monthly return of 3.4% and an annual return of 40%. I know, you would say “40% return? that sounds crazy!” To that, I would add: It’s not crazy, it’s ridiculous.
We are able to generate these returns by selling options as per the short straddle strategy. The whole process is really easy once we understand the basics. So, let’s begin with absolute basics
What are options?
Options are financial products and like company’s share, it can be bought or sold on exchanges including National Stock Exchange (NSE).
Generally, when two parties buy and sell company’s share, both have opposing views. The buyer believes that company’s shares are trading at a lower price and that price would increase in future. Thus, it’s in buyer’s interest to buy the share now at prevailing lower prices. The seller on other side views company’s shares to be trading at a higher price and expects that to go down. Thus, the best time to exit is not at current high price. As time passes and the share price moves, either the buyer or the seller stands corrected and thus makes profit on the deal. Consider a transaction where Sameer the seller sold shares of Reliance to Bobby (the buyer) at ₹ 2,500, next if the price moves up by ₹ 500, Bobby’s view stands corrected, and he will make a profit of ₹ 500 as he can now sell the same share at a higher price.
Options are different as it brings the element of time into the transaction. Like shares, the two parties buying and selling options in the market have opposing views, but the views are a bit different in this case. The buyer of options believes that stock price will move and defines a time period by when that move is expected. So, for buyer to win these two conditions need to be true a) stock price will move (move up or down) and b) within a defined period of time. The seller on other side of the table will win if any of these two conditions are not met. Consider a transaction where Bobby the buyer buys option from Sameer the seller saying a) Stock price will move up by 500 points or more and b) This will happen in next three days. On the third day if the price is up by 500 or more Bobby wins and thus stands to make profits, else Sameer will book profits. Note that if price doesn’t move by third day but did on forth, still Sameer wins as the second condition was not met.
What is Short Straddle Strategy?
Options unlike shares can have different properties. Options can be either call or put, each option has an expiry date and a strike price. These properties make options highly flexible. We can group multiple options having different properties to form a strategy representing our view of the stock prices, we call this group an option strategy. Short Straddle is one of the strategies.
When using the Short Straddle, our view is that prices will remain stable for good amount of time. Once we enter the strategy the longer price remains stable higher are the profits, on other hand if it (stock price) become volatile soon after entering, we can expect to lose money as well.
During a trading day the stock price movements drifts between being volatile and stable multiple times. Our target using the short straddle is to deploy the strategy during stable period and stay away during a volatile one. Thus, price movements are the key to make profits. So, do we know how to predict the price movements? Quite frankly NO. But on the brighter side we know a way to get around that.
What’s our secret sauce?
What to do when we can’t predict movements? It’s simple learn from history, take calculates risk and lastly be quick if we are mistaken. Here’s how we implement this plan:
Historically the stock prices are volatile during initial minutes of the day, thus we avoid entering the market at start. After the initial agitation probability of prices being stable increases, thus, we are ready to deploy and wait for prices to reach an optimal range. Once it hits that range, we send out buy/sell market orders for options to deploy the short straddle strategy, at this point we say that we have taken a position. While our strategy is deployed, we want the stability in movements, if stable we earn money but if prices are volatile, we can also incur losses. Since there is no certainty, we keep tracking the price movements. If it is stable, we would sit tight and keep booking prices, but the moment we feel that prices are becoming volatile and moving beyond our comfort zone but need to either switch our position to have a new comfort zone or exit the market entirely. By switching our position, we incur small lose but continue to stay active thus keeping the possibility of getting profits alive. If we choose to exit the market, it’s like turning off our devices and calling it a day. We like to equip with both the options and take appropriate action based on the prevailing conditions.
As an additional layer of safety, we also define a loss limit. There might come a day, a bad day, when most of our calls are mistakes and we keep losing money on each position. We want to end a day like this as early as possible. The loss limit comes into play here. Suppose we define a loss limit of ₹ 2,000, any given day the moment we incur a loss of this limit we will make an exit.
The key here is taking swift action, by quickly switching our position we ensure we have the most optimal strategy in place. The quick exit order on hitting the loss limit puts a cap on total loss for the day and thus we have the confidence that one bad day won’t ruin our overall profits. This here is our secret sauce, being quick to flex our strategy as per the prevailing conditions.
If we are relying on being quick, we know that we need to be really really good at it, and this is the reason we follow three steps repeatedly a) Track the market, b) Analyze the conditions, and c) Take appropriate decision. These steps although simple takes time for a human to process and implement and thus there are two additional elements to our plan:
Algo Trading
An algorithm is a set of logical instructions entered in a machine for it to follow. In algo trading, we code the three steps it into the computer and run it repeatedly. Computers although dump in intelligence are very fast when it comes to processing. By letting machines help us we are able to run all three steps track, analyze and act in less than a second and thus performing the whole task sixty times in a second or three thousand six hundred times in an hour. Say we entered a position at 9:30:00 AM, we will track, analyze, and act at 9:30:01 AM, again at 9:30:02 AM and again at 9:30:02 AM and so on.
Liquidity
Running an algorithm ensures that we are taking correct actions and doing it in timely fashion. Suppose there comes a situation when algo decides to take an action, maybe to switch a position or exiting the market, the algo by itself can only place market orders, we still need to rely on market for orders to be fulfilled. These actions will be frequent and thus market needs be ‘Liquid’. Liquidity of market is a feature whereby one can quickly purchase or sell products at fair price. In a highly liquid market one can expect all the orders to be fulfilled almost instantly which is the kind of support we need from market.
To ensure we have sufficient liquidity while trading, we only prefer to deal in highly liquid market of just NIFTY and BANKNIFTY. These are the options with highest traded volume in the market and thus highly liquid.
By employing algo trading in a highly liquid market we reduce our reaction time to uncertain market. This helps to increase our risk appetite because if we take a right call, we will make good profit but if we happen to take a wrong call we can reverse it before it costs us beyond our appetite.
How does the live trading look like?
We tested our short straddle strategy implemented using algo trading over a period of three months starting 17th May 2021 to 13th August 2021.
The capital in use for the strategy was ₹ 7,00,000. We need to have this amount in our account to be able to run the strategy. We only traded NIFTY options which are highly liquid. Our loss limit per day was ₹2,000, if we hit loss of ₹ 2,000 in any day, we exit the market.
Let’s look at some sample days:
June 24th, 2021
The market opened with NIFTY at ₹ 15,737 on June 24th, here’s how the day went by:
- 9:20:00 AM – The initial agitation is over, and we are now ready to enter the market. NIFTY was at ₹ 15,730, but to enter the initial position we need to wait until it trades near a multiple of 50, this will be an optimal position for us to make profit. We kept tracking the market every second, it moves around same price but is not in our range.
- 9:28:52 AM – NIFTY at ₹ 15,745, this is close to ₹ 15,750 a multiple of 50 and thus we can enter the market. Algo initiated the market orders for short straddle strategy, once these orders are fulfilled, we would say we now have a position in the market. Remember we want NIFTY to trade around this price, as time passes, we start to make money. More the time passes while NIFTY is stable more, we make money and thus we patiently wait.
- 10:00:00 AM – NIFTY is trading within our range and since we have held the position for a while now, we have made a profit of ₹ 1,350.
- 12:00:00 – Market – still withing our range. Thanks to the smooth passage of time our profits have increased to ₹ 2,295
- 12:19:56 PM – NIFTY has moved beyond our range, and we need to act. So far it has been a good day for us, and we can stay active in the market in anticipation of more profits. We decide to switch our position to adjust the range around current NIFTY price. Doing so we did incur some cost, that’s the price we pay to stay in the market. Our profits stand at ₹ 2,182
- 1:30:00 PM – Profit at ₹ 2,550
- 2:32:06 PM – We keep on tracking the NIFTY index and have had couple of position switches. But profits are now at ₹ 4,672.
- 3:20:00 PM – The exchange is about to close, and we don’t want to be caught up in the final minutes’ uncertainty. Thus, algo choose to exit the market and send orders to close all out existing positions. Thanks to amazing stability of the index, we made profit of ₹ 9,217 during the day.
Day’s Summary:
The market remained stable for most part of the day and thus we were able to hold onto our positions. In total we switched our position four times and the fifth time we simply exited the market closing all our position. We switch our position when we anticipate that current position is no longer optimal and might turn into losses if held longer. The position switching is coded into the algo and thus these orders are sent out automatically.
June 1st, 2021
This was one of the bad days we would not like to trade on, but things like these can’t be predicted in beginning and thus we started the day as a normal one. The day went by as:
- 9:15:00 AM – NIFTY opens at ₹15,629.
- 9:20:01 AM – NIFTY at ₹ 15,601. It’s time to enter the market. Since its already close to a multiple of 50 we take the position right away.
- 9:22:43 AM – Roughly two minutes into the entry we see an unfavorable move and need to act swiftly. We have just begun the day and it’s too early exit the market entirely. So, the algo decides to switch the position. Since not much time has passed, we didn’t make any money yet and instead are at loss of ₹ 352
- 9:25:55 AM – Another unfavorable move and SWITCH, tough day it seems. We have lost ₹ 1,455 by now.
- 9:59:13 AM – SWITCH.
- 10:17:53 AM – SWITCH.
- 10:20:40 AM – SWITCH. This seems like a blood shed. Our losses are also around ₹ 1,282.
- 10:22:24 AM: Our losses are now at ₹ 2,047. This is where we draw the line. Enough is enough, we say and the algo sends out market orders to exit all the position and calls it a day. The orders get executed almost immediately but due to slippage our losses increase to ₹ 2,235. The good thing here is that we realize the bad day and limit our losses.
Day’s Summary
This was not a good day to trade due to such frequent movements, we were just an hour into the day and losses added up to more than two thousand. On the optimistic side we had the algo with all the instructions pre coded and it sent the closing orders as soon as we hit our loss limit.
The above two days were where we made highest profit and the biggest loss during the entire period while remaining days were somewhere between these two. A summary of what happened during the whole period is as:
Average daily profit we made during the period was ₹ 1,124.
Out of total 64 trading days, we made profit on 43 days while loss on 21 days. On the days we made profit we made average of ₹ 2,508 while on loosing days we lost ₹ 1,710.
There were days when the index movements were at peak.
- On Monday, June 21st, 2021, NIFTY moved up 220 points, we made a profit of ₹ 3,982 that day.
- Two days later Wednesday, June 23rd NIFTY fell 175 points. We lost ₹ 2,000 that day.
- On Tuesday, August 3rd we were on track to make a big loss of ₹ 4,282. But thanks to our loss limit the losses were limited to ₹ 2,047
This has been a brief analysis of the Short Straddle Strategy when run of NIFTY index. The Short Straddle is amongst the most basic options selling strategy and is wide known. Even with huge popularity this strategy can deliver amazing returns, this is possible because a) There is still huge potential in the market for options selling and b) Use of efficient processing, the faster we process the better results we get.
Please get in touch with us for a detailed analysis of the strategy.
Disclaimer
The results presented are based on back test we conducted on the NIFTY options
We have assumed market to be highly liquid, which might not be true in real scenario
We have not incorporated brokerage charges as it differs from one broker to another. Besides, the brokerage charged by discount brokers are nominal compared to the gains mentioned.
Hitesh Gulati, CFA 