How to use options when markets are directionless - Motilal Oswal
How to use options when markets are directionless - Motilal Oswal

How to use options when markets are directionless

We have heard of bullish markets and we have heard of bearish markets. What if markets are neither bullish nor bearish and it is really hard to predict the direction of the market. These are called directionless markets. The advantage of using options is that you can also use tailor made options strategies for these kinds of directionless markets. But first what exactly are directionless markets and how do we define them?

Understanding directionless markets
There are two approaches to understanding directionless markets. The first is a volatile market. Volatile markets can be volatile in either direction i.e. on the upside or on the downside. The only key takeaway in volatile market is that the volatility as measured by the VIX is increasing. The markets are at the cusp of a major breakout but you are not sure which direction this breakout will happen. That is the dilemma. This expectation of higher volatility is one example of directionless markets.

The second approach to directionless markets is a tepid or lacklustre market. Here the volatility is falling sharply and that means the market is going to be range-bound in a very narrow range. The question is what do you do? When markets are bullish or bearish, you are quite clear what to do. But the big question is what to do when markets are directionless. The answer is you can either adopt volatile strategies or range-bound strategies based on your expectations. Here is how you go about it.

Four strategies to play directionless markets
Broadly there are 4 ways to play these directionless markets. Each of these can be played for volatile market expectations or for range bound market expectations..

Using straddles for directionless markets
In a straddle you buy the call option and a put option of the same strike price. Effectively, you are betting that the market index or the stock is going to give a breakout but you are not sure which direction this breakout will happen. Infosys is a classic example on its results day. In the past there were quarters when Infosys has outperformed on the results day and there are enough occasions when it has underperformed on the results day.

Let us say Infosys 1100 call option is quoting at Rs.25 and the Rs.1100 put option is quoting at Rs.50 while the current market price of Infosys is Rs.1090. You can create a straddle by buying one lot of 1100 call option and one lot of 1100 put option. The total cost of the straddle is Rs.75, which is the sum of the premiums of the call and the put. So you are profitable either if the stock price of Infosys goes above Rs.1175 or if it goes below Rs.1025. When either of these limits is breached your straddle becomes profitable. You are betting on the volatility rather than on the direction of Infosys price movement.

Alternatively if you are expecting Infosys to be range bound between 1050 and 1150, then you can sell this straddle. As long as the stock stays in the price range of Rs.1025 and 1175, you are going to be profitable on the short straddle. Remember, short straddles are open-risk strategies as outside this range your losses can be unlimited. Also short options entail initial margins and MTM margins.

A slight improvement to the straddle in the form of strangle
A slight improvement of the straddle is the strangle strategy. While the long straddle, buys the call and the put of the same strike price, the strangle strategy uses a higher strike for the call and a lower strike for the put. This gives you two advantages. Firstly, since you are widening the gap between the call strike and the put strike your premium cost will come down. Secondly, when you are expecting range bound markets, a short strangle will give you a much wider protection range as compared to a straddle. In practice, strangle strategy is a lot more popular than straddles for directionless markets.

Using a long Butterfly spread strategy for directionless markets
As the name suggests a Butterfly strategy combines selling 2 ATM options and simultaneously buys 1 ITM option and 1 OTM option. The net result is a small debit which is the maximum cost of the butterfly spread strategy. Remember that there are 4 legs to a butterfly strategy and 4 legs at the time of closure of the strategy. There is transaction cost and statutory cost implications on all these 8 legs and that needs to be factored into your calculations.

Using a long condor spread strategy for directionless markets
A Condor is basically an extension of the butterfly strategy. The only difference is that instead of selling 2 ATM options, the strategy sells 1 ITM option and 1 OTM option. Again, there are a total of 8 legs in initiating and closing out this transaction and that needs to be factored into your calculations.
The point to note is that you need not fret that markets are directionless. Options provide you the leeway to also play such unique situations in the market.
 

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