A short-volatility test on Nifty returned 11.3% a year, inside a 15% drawdown
Indian retail traders sell index option premium more often than they do almost anything else. Two questions follow from that. Is the premium genuinely there to be collected? And can it be collected without the occasional week that erases a year of it? We tested both on ten years of Nifty data. The premium is real and stubbornly persistent. The version of the trade that stayed inside a hard loss limit returned 11.3% a year, with a maximum peak-to-trough fall of 15% and no single week worse than 3%.
The raw gap comes first, because everything else rests on it. India VIX, the index that summarises how much movement option prices are anticipating, averaged 16.5% across the period. The movement that actually turned up over the following 21 trading days averaged 14.0%. That 2.5 percentage point difference is the volatility risk premium, and it was not an occasional thing: implied sat above realised on 80% of days, four days in five.
None of this is peculiar to India. Insurance sells above its expected cost in every market anyone has studied, for the ordinary reason that the buyer of protection wants it more than the seller wants the cash. What matters to a trader is not whether the premium exists. It is what reaching it costs.
Reaching for it the crude way means the naked weekly short straddle: sell a call and a put at the money, collect the credit, and hope the index stays put. On our numbers that earned 0.22% a week on notional and produced a Sharpe ratio of 1.12. Sharpe is return measured against the size of the swings taken to get it, and anything near or above 1 is respectable. Eleven years were covered and ten of them finished positive.
And then one week took 12% off the account. That is the entire character of naked short volatility in a sentence: a long run of small wins, interrupted without notice by a single loss big enough to undo them. Because the study was run against a firm ceiling of 15% on drawdown, the deepest fall from a previous high in account value, a structure that can drop 12% in five sessions with no floor under it was off the table.
Capping the tail changes the arithmetic completely. The defined-risk version sells the same at-the-money straddle but buys further-out options on either side as wings, so the worst possible outcome is fixed before the week begins. With wings placed two standard deviations away and a fixed 3% of capital risked each week, the test returned 11.3% a year at a maximum drawdown of 15%, with a Sharpe of 1.27 and ten of eleven years positive. The worst week was 3%. That is the same tail event that cost 12% unhedged.
Those are the best risk-adjusted numbers this research has produced, and more interestingly they come from a different kind of edge. Almost everything else that has survived our cost assumptions is some flavour of equity exposure dressed up as a signal. Short volatility is not. It earns when nothing much happens, which is exactly when trend and momentum earn nothing.
The settings were not free lunches, and the trade-offs deserve stating plainly. Pulling the wings in to one and a half standard deviations, at the same weekly risk, lifted the annual figure to 13.7% but pushed the worst drawdown to 23%. Keeping the wider wings and raising weekly risk to 5% produced 19% a year at a 25% drawdown. Both blow through the budget. No setting produced a materially larger return while holding the loss limit. Return scaled with risk, precisely as theory says it should.
Now the part most write-ups leave out. No real option prices went into this. Weekly at-the-money implied volatility was stood in for by VIX, the legs were priced with a symmetric model, and costs were assumed at a flat 2%. Every one of those choices flatters the outcome. VIX overstates weekly implied volatility somewhat. A symmetric model ignores the skew that makes index puts dearer than calls, so the protective wings would really cost more and the credit taken in each week would be smaller. A flat cost assumption is generous against the bid-ask genuinely crossed on a four-legged position, every week, for a decade.
Crowding is the second caveat and may be the bigger one. Selling Nifty premium is the single most popular trade in Indian retail. A premium that everybody is queuing up to sell tends to shrink, because that is what competition does to a price. A backtest measures the premium of the past decade, not the one waiting for the next person who tries.
Scale is the third, and it is the least fashionable thing to say out loud. Roughly 11% a year at a 15% drawdown is a solid, diversifying result. On a small account it is not a life-changing one. That is close to the honest ceiling for anything genuinely risk-controlled: a bigger number requires accepting a deeper drawdown or bringing more capital, and there is no third door.
Making this real is straightforward and unglamorous. The exchange publishes its own daily record of weekly option prices for free; swapping that in for the approximation would capture true skew and the actual cost of trading four legs, and the whole thing can then be run again. Until that happens, the 11.3% is a measurement of a model rather than of a market. Everything above describes what one set of rules would have done across a decade that has already been and gone.
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