The election results are scheduled to be declared on 16th May 2014. Equities have become highly volatile on account of the uncertainty that is involved in the outcome of the election results. The hopes of better governance and sound economic policies from the new government that would come into power has taken markets to all time record high levels.
The Sensex and the Nifty reached record high levels of 22,939 and 6869 respectively on expectations that the NDA led government would come into power. Even though there is a widespread expectation that Modi led government would come into power there is always an uncertainty that gives rise to increase in volatility for equities.
The month of May has seen a significant rise in the volatility for the index and stock based options. The Nifty index options have implied volatility to the level of 31% for at the money Put options and 28% for at the money Call options. There has been a rise in the implied volatility by 234% from the levels of 9.27% for at the money put options and by 97% from the levels of 14% for at the money call options that were seen for the Nifty index April 2014 series. The implied volatility for out of the money put and call options are not much below at 29% and 27% respectively.
The spread in the implied volatility for at the money and out of the money call and put options shows buying at all levels to ride the election event. The rise in the implied volatility has significantly increased the option premiums for the Nifty index May series. The costs have dramatically increased for the purchase of Nifty index options in the month of May 2014 as compared to the previous month. For e.g. April 2014 out of the money put and call options of 6300 and 7100 were costing Rs.615 for one lot of 50 for the Nifty index at the beginning of the month of April and the May 2014 Nifty out of the money 6300 put and 7100 call option have a combined cost of Rs.9550 at the beginning of the month of May that shows a 15 times rise in cost of purchase. High expectations have already increased premiums of the May option series to abnormal levels.
There are six factors affecting the price of a stock option, the Stock Price, the Strike Price, the time to expiration, the volatility of the Stock Price, the Interest rate and the dividends expected during the time period of the Option.
The interest rate and expected dividends have not changed from the month of April to May. The volatility has increased, as a result of which the premiums have surged for the month of May. The time to expiration till the outcome of election results on 16th May will reduce. The volatility is expected to remain high till the election results and therefore even if the premium decreases due to decrease in time to expiry the increase in volatility would tend to increase it.
According to our view it is wise to stay away from any option strategies at least till the election results are announced as high costs may drive returns lower than expected. If Election results are on the lines of expectation then the market would rise but if the results are not according to expectations then the market might witness a steep fall from current levels. The fall and rise has to be equally steep for the options to give extraordinary returns but if markets remain range bound then option premium may see a drastic reduction in a very short time period.
The election results that gave majority to the UPA in 2009 had seen a 20% rise in the benchmark indices in a single day. The markets were trading at a significant discount to the valuations as the whole world was recovering from the 2008 financial crisis. In the current scenario a 20% upside may not be justified as markets have already factored in the expectations of the election result in the valuations. A moderate upside can be justified in the benchmark indices if everything turns out as expected. An opposite result may see a steep fall in the indices which has a low probability. An option strategy may be implemented just after the results are declared so that costs can be managed effectively.