I got the idea of this from a book that mentioned that portfolio investors like to buy 10% out of money options (OTM) for hedging their portfolios. It got me thinking:-
- Isn’t 10% way too much out of money?
- Will this money used for hedging not get wasted?
- Is it worth the trouble?
Instead of checking the fact, I just went ahead and bought five 5000 strike Nifty puts on 1st August’ morning. Nifty kind of crashed after that so I booked at 900% profit on monday, just one week later. Today I mentioned the fact that I made 10 times my investment (Rs 20,000 made on Rs 2,000 invested) at Vtrender trading chatroom. My good friend RM from the trading room discussed the possibility of testing the strategy of buying deep out of money puts as a money maker. Now RM is good with scripting and logic but the task is quite complicated because it needs lot of data crunching and scripting. So we decided to put away the testing of this strategy few days away.
However, being impatient, I decided to do a quick-and-dirty testing first and simplified the task by using a few simple rules to find out payoff of this strategy. Boring assumptions are at bottom. Interesting results are right below.
- Out of 53 months, OTM puts struck money in 3 months. In rest of 50 months, they expired worthless.
- A total of Rs 3,40,280 (Rs 3.4 lac) was invested. On avg Rs 5970 per month.
- Total payoff was Rs 5,68,200. That means a profit of Rs 2,27,920.
- Profit is 67% of investment!
- On a per month basis profit is Rs 4000
- To make a similar return from 9% FD, you would have to invest Rs 5,33,000 on 1st Jan 2007 upfront. I don’t want to go into calculating the two strategies on NAV basis but I am pretty sure OTM put strategy is giving almost twice return compared to 9% FD. Those who would like to keep their FDs could put their FD interest every month into this strategy and get win a lottery every 17th month or so.
- Negatives of this strategy: Who has patience to wait 17 months before striking paydirt! This return is not fantastic; I want to make 10% every month! This is like a lottery!
- Positives other than returns: If you are an investor in equity market and are holding these puts the day Nifty crashes and hits circuit breaker, you will thank me and thank god. In that order.
While the strategy made intuitive sense to me it right away, it seems profitable even when applied mechanically. So go ahead and hedge your longs. Your money will be returned back to you by market automatically. All you have to do is buy ten (maybe 100) 10% out of money puts on 1st day of every new series in Nifty options and hold till expiry. Don’t think, don’t act after that! Of course if you think you can outguess the market, go ahead and make some variations. Make it your own!
Boring Assumptions:-
- Period used 1st Jan 2007 till 31st July 2011. For those of you thinking this strategy may not work prior to that period because Nifty was in a strong bull market, check out months of May 2004 and May 2006. This strategy would have rained money in those months too.
- Day of buying of put options changed from first day of series to 1st trading day of calendar month because did not have patience of plugging in 57 dates carefully into my spreadsheet.
- Day of selling of option similarly changed to last trading day of calendar month.
- Option strike assumed to be rounded down figure 10% below closing price on 1st trading day
- Cost of options assumed to be 0.12% (on 1st August cost of option was 0.10%) on average.
- Brokerage cost assumed to be Rs 100 per option both ways.
- Options are not encashed at any discretionary level. Assumed to automatically expire at closing price of last trading day of calendar month.
