Start hedging for an event risk

After eight weeks, call option buyers heaved a sigh of relief last week. Notably, there was short covering in some good but controversy-hit financial sector stocks. This is an indication that any fresh decline in this sector would require further bad news, and if that is not coming forth, probably things will settle down in this space. But that doesn’t mean that every NBFC stock will make a comeback. Far from that, the firms that were hit more by sentiments than real issues would make a likely comeback. There would be phases when they get a disproportionate share of flows.

Whether or not assembly elections make a long-term difference to the market is an issue of debate, but in the short-term they surely have the potential to bring volatility to the street. Volatility often wipes out all profits made by a trader. While the election results are going to come next week, the hedging cost tends to increase as the event nears. So, it is better to hedge both long and short positions now. Yes, hedging both sides will raise the cost, but there is no escape from incurring some cost to protect the value of one’s portfolio from event risk.

Coming to strategy for this week, it would be better to buy straddles or strangles. Straddles should be bought close to the end of this week, so that the strike price selected is close to the level from where a directional move is expected. In strangles, some position could be taken at the start of the week, but the major portion of the trade should be taken around the close of the week. But do not go very far from at-the-money options in strangles. Because, when volatility hits the market, close-to-the-money options give better returns and even the options which are not giving return have some time value that can be salvaged in case a trader decides to carry on with the leg of trade after the event is over. But it would be advisable that both legs of the trade should be closed when the combined value of the straddle and strangle give a decent enough return on the trading capital employed.

Similar strategies can be used on the Bank Nifty, too, but it would be preferable to go for at-the-money straddles rather than out-of-the-money strangles, given that the Bank Nifty is outperforming the Nifty at this point and when that is happening, volatility tends to be short-lived compared to the Nifty. Also, traders who are about to take fresh positions in individual stocks should ideally take the exposure through individual stock options rather than individual stock futures.

Rajiv Nagpal