By: Sayantan Ghosh
Global stock markets have significantly fallen off their highs of January, 2020 and still there are chances they haven’t bottomed out yet. Though traders can make money off this steep fall by taking short positions on securities, can you hold on to them for a month or carry over this shorts to next series? Can you make the most out of your money by consistently profiting off this directional market movements? Let me tell you how.
Let’s start with a simple mathematical concept – Probability. What this topic does is associate a mathematical value with your expectation of a likely outcome. Options are rights to the same. Do you think a stock currently trading at 100$ can reach 120$ within this week? Or can it fall to 80$? The probability of this outcome turning out to be true is what lays the foundation for Options.
So, what are the factors that can change this probability?
a) Time: Of course, the more time you have, the higher the probability that your expected outcome will turn out to be true and you can exercise your options in the money.
Let’s say you have Bank Nifty currently at 18000 and you have a weekly and a monthly Call option with strike price 19000. Since it is more probable that Bank Nifty will reach 19000 within a month than just a week, the value of the monthly option will be much higher than the weekly option with the same strike price (19000). This is known as ‘Time Value of an Option’.
b) Volatility: If a stock or index moves 200 points in a day and if the same stock/index moves 500 points in a day, which has more probability to cover the 1000 (19000 – 18000) point gap quickly? Of course, the one where there is a 500 point movement, right? This is one of the most crucial factor in Option pricing and neglecting this leads to losses in case of maximum no. of traders.
If you are trading in Options for the first time, you must have a certain idea of the Market Volatility at the time you take any Call or Put option position. For this, you need to check a crucial macro index: INDIA VIX.
How to interpret INDIA VIX?
a) When you buy an Option, you are basically paying for the associated probability. If INDIA VIX is higher, the probability of your likely outcome becoming true increases and hence, the value of the Option Premium increases and vice-versa.
b) Even if you predict the direction correctly and INDIA VIX decreases, the implied volatility of the option decreases, thereby reducing the probability of your expectation coming true. This is reflected in a reduced Option Premium and you may end up in a loss inspite of choosing the right trade direction.
Let’s start with a real-world illustration and make this easy for you to understand. For this example, I am going to take the underlying as Bank Nifty (one of the major Indian market indices).
Bank Nifty has fallen down from 30000 levels to almost 16000, and after a ‘dead cat bounce’, is around 17300 at the time of writing this article. There was a recent correction from 16000 to almost 21000 in the last few days and so, we are going to track the movement of Bank Nifty and two options:
a) A European Call option: BANKNIFTY APR 19000 CE
b) A European Put option: BANKNIFTY APR 19000 PE
Before proceeding, let’s take a moment to understand what the Option terminology means:
i) BANKNIFTY: Since it is a derived product of the Bank Nifty index.
ii) APR: It means that the Option is going to expire on the last Thursday of April, 2020 (30th Apr, 2020).
iii) 19000: It is the Strike price of the Option. This means you expect that Bank Nifty will close above 19000 (if you are a Call option buyer) or below 19000 (if you are a Put option buyer).
iv) CE & PE: These stand for Call & Put options, exercised in European style (only on the day of expiry).
Now, we track the movements of both the Call & Put options over the last few trading sessions:
Tabulation of the Option vs Underlying (Bank Nifty) tracker output:
Thus, from the above table, it can be seen that Volatility plays a huge role in determining the Option price as smaller changes in Bank Nifty get higher magnification in form of Option price movements. On 31st March, even though Bank Nifty increased, both Call & Put Options fell along with a 10% fall in VIX as reduced volatility implies less probability of any option expiring in the money.
This basic understanding of Implied Volatility (IV) can be utilized to make profitable trades in the F&O segment. On days where the VIX is low, it is advisable to either write/sell options or book small profits & do multiple trades, instead of holding options for long periods, as the time value will deteriorate faster in Low VIX trading sessions.
Always remember, Option trading is a game of probability. As the probability of your underlying stock/index hitting the Strike price increases, so increases the value of your option & vice-versa.
That’s all for this introductory part. In the upcoming article, we’ll learn about Intrinsic value of an option, Interest rates and various Greeks related to Option trading. I’ll also try to give a detailed overview of Option Chain analysis and Information Mapping so that you can improve your trade strategies.
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