“The Art of War” is a famous Chinese book on military strategy believed to be written by Sun Tzu, military general, strategist and philosopher, in the 5th century BC. It has been applied to many fields well outside of the military, and its philosophy has found use to improve leadership skills and increase chances of victory, by leaders and strategists in fields ranging from sports to science and business to politics. Trading in stock markets is not dissimilar to waging a war, in terms of what is at stake, the unknowns, the constantly changing conditions, and the need for planning to emerge victorious. How far are these centuries old theories applicable to the new age stock market dynamics? To investigate this, I dug up some of our records from February 2018, when my team found itself in a similar position that required careful strategizing.
If you know the enemy and know yourself, you need not fear the results of a hundred battles. -Sun Tzu, The Art of War
Understanding Nifty’s build up &the potential for a big trade: Shortly before February, Nifty had corrected nearly 4 percent twice, once each in November and December 2017. But by January it began to show signs of raging bull market again, having broken above the 2017 peak. This raised a few questions. Is it time to opt a long term investment view in anticipation of repetition of 2017’s year long gains? Nifty 50 index was still going from strength to strength. Midcap 100 index had dipped 2.5 percent from the peak in January. Is it time to calibrate a midcap centric long term strategy?
He who knows when he can fight and when he cannot, will be victorious.- Sun Tzu, The Art of War
Deciding to act now, or wait: And then in February, the falls began. On the 1st of February, It was steep, but Nifty ended the day with a doji candle1, leaving us tentative on whether to dump the long oriented strategy favoured earlier. The next day’s fall ended up with an unusually long black candle2 almost convincing that we have entered a major correction phase, atleast as big and sustained, as the one seen in 2015. Yet, we were careful not to rush and opt for all out bear strategies. On 6th February, the third day of the falls, Nifty opened gapped down3, leaving us a tad disappointed that we were now late to act now on the sizeable moves that were in play. There were large profitable moves to be made, or positions to be saved, but we hadn’t taken a clear stand as yet. Incidentally, in a few minutes, Nifty began pulling back swiftly, and we sensed that a window is opening up for a strong trade, and we had to decide.
Analyse data. Given the volatility, we decided on drawing up an option strategy that would have left a fair chance of benefitting from gigantic moves. Naked calls or puts4 on the long side were not favoured due to the lack of protection in the event of an unfavourable move; especially since uncertainty was high. Given the suddenness and breadth of the move, and with expectations of more, a long straddle5/strangle6 emerged as the convenient choice. To be sure, we collected as much data as we could, that would give us the pulse of the ongoing move and we observed that Volatility index (VIX) had been consistently rising since December 26, 2017 and had peaked to 23 near about on February 6th. It was now in the vicinity of record peak volatility having almost doubled from 12 during that span. This persuaded us from the long strangle/straddle strategy. Meanwhile, Nifty’s RSI7 had also crossed 80 mark for the first time since June 2014 on 23rd January 2018, hinting that the market was turning lower from an extremely overbought situation. So, Nifty had been vulnerable for correction, and was ripe for even more.Further, Nifty had plunged approximately 8% from the peak to the low value of February 6th. On February 6th, IV of ATM strike (10400) pushed above its 15 day average historical IV for the first time, effectively ruling out strategies that had option longs.
The general who wins the battle makes many calculations in his temple before the battle is fought. The general who loses makes but few calculations beforehand.- Sun Tzu, The Art of War
Zeroing in on the short straddle8: From the 11,000s, Nifty would eventually fall below 10,000 in just a few months, but 2 to 4 percent moves on either sides became quite common. And we wanted to avoid being on the wrong side of such strong moves, and hence we opted not to go for naked longs. Moreover, the long build up prior to 1st February, and the crashes thereafter had swollen both call and put premia, and were vulnerable for falls. Most importantly, February’s expiry fell on 22nd, which meant there were fewer days to expiry. In other words, if there was a fruit that was worth plucking, then it was theta9, or time decay. And by having two legs on the short side, the short straddle strategy was best designed to benefit from the decaying of premia with time. IV had also peaked, and was getting ready for a knock, further boosting the probability of success of the straddle strategy.
Military tactics are like unto water; for water in its natural course runs away from high places and hastens downwards. So in war, the way is to avoid what is strong and to strike at what is weak.- Sun Tzu, The Art of War
|Entry Date||Option Strategy – Sell Nifty Straddle|
|06.Feb.18||SELL 10400CE @ 176 and SELL 10400PE @ 177, in equal lot(s)|
Ensuring a profitable exit: Having established a position early in the month, the challenge was to stay put to the end of the course. Usually, and especially with a winning position in hand, there is an urge to make changes, which may ultimately give away the advantage. There was also a temptation to book profits midway. Luckily theta decay was on our side, giving the short positions ample cushion, and hence we held on to the positions as long as we could. On the day before expiry, when we chose to close out the positions, Nifty was seen ambling around 10400, which was also incidentally the Nifty level at the time of entry. This is a magical place to be in, because theoretically, it squeezes the maximum juice out of a straddle position. And for that to happen, not only would you require all your calculations to be right, but it would help to have a bit of luck also on your side. But then, the luck stands a chance only if you get the calculations right, in the first place; which we had.
What is essential in war is victory, not prolonged operations.- Sun Tzu, The Art of War
|Short Straddle on Nifty – Status on 21st Feb 2018|
Conclusion: The stress that Sun Tzu has placed on positioning in military strategy cannot be overstated. In stock trading too, the choice of investment strategy and its deployment needs to be based on understanding of the market conditions, your own capabilities to take risk and employ capital, and the factors that are likely to influence those conditions. But having a plan or a to-do list for these aspects cannot be construed as strategizing. Market conditions change; why, even you can change. When you have drawn up a plan to counter a change in plan, then that is when strategizing begins.
1 A neutral pattern in candlestick chart which looks like a cross, inverted cross or plus sign with an open and close that are virtually equal. It also signifies equality and/or indecision between bulls and bears. A doji is often found at the bottom or top of the trends and thus is considered a sign of possible reversal of price direction or indecision.
2 A black or red candle is formed when the closing price below the opening price indicating the price fell on that day.
3 The open price being lower than the previous trading day’s low.
4 A single leg option strategy, buying/selling a call/put option without any protection. Ideally, naked option strategy provides the highest profit potential, but the risk is also commensurately high.
5 An option strategy that involves simultaneous buying of an at the money put and an at the money call of the same underlying stock, strike price and expiration date. This produces a position that will profit if the underlying stock makes a big move either up or down during the life of the option.
6 An option strategy that involves simultaneous buying of an out-of-the-money put and an out-of-the-money call of the same underlying stock and expiration date. This strategy does best if the stock price moves sharply in either direction during the life of the options.
7 The relative strength index (RSI) a line graph that moves between 0 and 100. It is a momentum indicator that measures the extent of recent price changes to evaluate overbought or oversold conditions in the price of a stock or other asset. RSI values of 70 or above indicate that a security is becoming overbought or overvalued and 30 or below indicates an oversold or undervalued condition.
8 An option strategy that involves simultaneous selling of a put and a call of the same underlying stock, strike price and expiration date. It becomes profitable if the stock price and volatility remain within a small range.
9 Theta is a measure of the rate of decline in the value of an option due to the passage of time. It can also be referred to as an option’s time decay. If everything is held constant, the option loses value as time moves closer to the maturity of the option.