How To Trade Options, When The Trend Is Not Clear

How To Trade Options, When The Trend Is Not Clear

Amplify Trading Academy  | Sep 17, 2019 16:28

We are all aware of choppy markets. It’s the kind of market that doesn’t have a defined direction. The current Nifty September contract is a perfect example of a choppy market scenario. September contract opened at 11006 and plunged to 10785. Thereafter it registered a high of 11118 and again fell more than 300 points as it hit a low of 10807 today. The important question is how professional option traders trade such choppy markets. The answer is, they build Positional Option Spreads. The question is how can we create these Positional Spreads at a retail level? To find out, first, let us understand what option spreads are.

What are Spreads?

One of the most lucrative methods of options trading is by building ratio spreads. A spread is an intelligently crafted option sequence which involves two or more options of the same type. In practice, spreads have two legs. One leg is created to generate returns, the other acts as a protective cover. Take for example a trader is long one lot of 11200 calls @ Rs30 and shorts 2 lots of 11400 call @ Rs10 each, at a time ‘t’. To execute this options sequence, the trader pays Rs.30 to buy one lot 11200 call and receives Rs.20 by selling 2 lots of 11400 call. The net value of the spread, therefore, is Rs(20-30)= Rs-10. This implies that there is an investment of Rs10 in this spread for the trader. So what is the advantage of creating a spread and how does one choose the strikes? These questions, we shall address later in the article.

Positional spreads

Positional Spreads have two unique characteristic, firstly they are designed to be direction neutral. This means the trader has the advantage of holding his position irrespective of the trend or market volatility. Let’s keep in mind that this spread starts with a net pay-in, therefore the coefficient of covariance between the vega and theta should be placed intelligently to offset all kinds of premium expansion due to volatility spurts.

Look at it this way, there are 4 participants A,B,C,D in 400 meters race. A, is standing in the inner most lane and D is starting from the outermost lane. You’ll notice that D’s starting point will always be ahead of “A”. This is simply because the organizer wants to offset A’s undue advantage over “D”, caused by the shorter inner circumference.

In other words, the our spread needs to be crafted in such a way that the pay in from the theta premium can offset the payout from the vega premium even if the market is hit with excesses volatility due to an event or news. This explains the sheer advantage of the Option Spread Trader under all market conditions.

How To Identify The Strikes

Consider a situation, where your position needs to be trend neutral. We all know that trending markets causes the option premium to rise. This implies that during a trending market the options gamma must expand and the IV of the option must offset the theta decay.

Now let’s turn the situation inside-out. Let us assume that we want to remain trend neutral. We want our position to float alongside the market and ensure that it bags the constant theta decay as time passes by. This is where we need to meticulously calculate the forward sigma for the contract as it drifts closer to maturity. In theory volatility is independent of the time to maturity. However, Positional Spreads for all practical purposes are driven by the coefficient of covariance between the Vega and the Theta of the spread. Therefore what we need to solve this by establishing a sequence of strikes that will generate the perfect balance to offset the uncertainty for the month. So deal with it one step at a time. First, work on determining the forward sigma factor. Then establish the theta decay. The last step is to derive the coefficient of co-variance between the theta and vega to identify the strikes. The rest is about waiting for the premium to melt away with time.

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Avinash Talele
Avinash Talele

Thank you for a crisp explanation !  ... (Read More)

Oct 02, 2019 11:35 GMT· Reply
Bibek DUTTA
Bibek DUTTA

"Choppy markets" Nice word use sir .. It's really no can't understand After 30 second Game can change again same game recover after 30 minutes .. Trader confused ... How to take trade what is the proper Entry time . Every day they are changing Candle Bar .. Today You just see the bank nifty ... situation ... HDFC bank and suddenly change 27500 CE Rs 134 Rs 55 the game 26900 PE suddenly Rs 32 to Rs 78 once time both price sustaina Rs 55 / 56 Long time again Start same game . Some Advisor company gave me 27500 CE entry at Rs 110 and Target - 230 .. but I don't take it because I was confirmed that market Will go down ... I have trade 4 times on 26900 PE only Investment of RS 34000 and take profit 24500/- ☺️☺️☺️   ... (Read More)

Sep 18, 2019 20:53 GMT· Reply
Santo Barrys
Santo Barrys

.. Also selling options requires big premium right..   ... (Read More)

Sep 17, 2019 21:10 GMT· Reply
Santo Barrys
Santo Barrys

simplicity.. Mind blowing.. Take a bow bro  ... (Read More)

Sep 17, 2019 21:09 GMT· Reply
Saba Durai
Saba Durai

Good one for novice traders.  ... (Read More)

Sep 17, 2019 18:15 GMT· Reply
anil kumar
anil kumar

Hi. Can you pls tell us how as retail traders can we plot covariances between greeks to identify entries and exits. Is there some tool or website for this  ... (Read More)

Sep 17, 2019 14:09 GMT· Reply
Vikas Shett
Vikas Shett

Very nicely explained. Thanks  ... (Read More)

Sep 17, 2019 14:04 GMT· Reply
Ratnadip Banate
Ratnadip Banate

Dear Sir, when i try to sell 2 lot of option , i am getting insufficient available margin error, how to initiate spread in Zerodha kindly explain  ... (Read More)

Sep 17, 2019 12:22 GMT· 1 · Reply
Yogesh Bhate
Yogesh Bhate

Sir , when to exit from such a option. sprade?  ... (Read More)

Sep 17, 2019 11:48 GMT· Reply
Mighty Moustache
Mighty Moustache

Please guys he is trying to explain something, either you can educate yourselves by doing a search on the net or just moving on. Respect.   ... (Read More)

Sep 17, 2019 11:43 GMT· Reply
Vinay Kumar
Vinay Kumar

Can you please keep your posts simple and lucid rather than simply showing off your intelligence and throwing jargon?  ... (Read More)

Sep 17, 2019 11:37 GMT· Reply
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