It is a common practice amongst option traders to depend on charts to determine the trend and then buy or sell options. However, we know how difficult this technique is in determining the strike and then identifying the entry or stop and managing the risk. In today’s article we shall find 3 essential elements of Option trading that will eliminate these hurdles.
Identify The Time Lag
Take for example, you buy Nifty Futures at the beginning of a contract @ 8300 and hold it till expiry. We know that there is zero theta decay in futures. Now ask yourself, where must the price be at the end of the contract, for you to break even? Well, the answer is 8300. Reason being, your cost price = your selling price, and there is no cost of carry.
Now imagine, you buy a Call option of 8700 @ Rs. 200 at the beginning of the contract when Nifty was at 8300 and you hold it for a month. We know there is a theta decay variable that needs to be adjusted every day. Now ask yourself, if Nifty closes at 8300 at the end of the contract, will you be at breakeven? No, you will lose Rs.200. So what you just observed is a phenomenon called time lag.
In a time lag scenario, the buyer who purchases the time component of an option premium will lose money due to theta decay. The important question is where did Rs.200 go? Well, that money is equal to the volatility adjusted time value. Thus it lies in the bank account of the option seller. So why did the option buyer lose money? First let us understand what the buyer must have done. He studied the charts, which told him that since Nifty has broken a certain resistance, the next target was 9000.Therefore he was right in buying the 8700 Call option, but the question is how much time will Nifty take to achieve 9000? That is what will decide whether the 8700 Call option will settle at Rs.300 or zero. In reality, if Nifty des not close above 8700 by the end of the contract, the 8700 Call option would be reduced to zero.
Calculating the Option Premium
The value of an option premium is determined by the price a buyer would be willing to pay for the underlying, at time “T2”, assuming that the point of inception is “T1”. The data point we are using here is a steepening demand curve, which looks very similar to a flat “U”.
Suppose we add more inputs in this calculation. Between T1 & T2, we are trading Nifty during an event day. In this condition depending on the immediate demand in the Call option we have to maintain a steep curve or invert it depending on real time demand scenario. We must keep in mind that the time curve remains intact. If the demand curve is inverted then the outcome will be even more dramatic. The same buyers would now prepare to sell as they would look to exit long positions or build fresh shorts to recover their losses. This sudden switch triggers high Volatility.
Therefore the 3 elements that determine the price of an option premium are, the shape of the demand curve, time till expiry and the subsequent change in volatility of the underlying. If we combine these three elements it gives us a volatility adjusted pricing model. This is why Terminal Volatility is a good method to determine whether a premium is overvalued or under.
In our previous article “How To Neutralize Option Mispricing”, we have discussed in detail how the terminal volatility model was used to sell 3 lots of 8700 Call in the weekly contract @ 109 and 1 lot 9500 Call was bought in the monthly contract @ 319. The spread started with a credit of Rs.8 and closed @ 217 in the afternoon. This spread obviously appeared to be a high risk position if you didn’t know what your stop should have been. So the question is what if Nifty hits 9000? Why 9000, Nifty might hit 12000!
Here the value of Nifty which is the underlying is not relevant at all, because you are not looking at the chart. You are using the volatility adjusted time lag to determine how much over valued is the 8700 call option. Hence the terminal volatility gauge determined the risk component at 25.Therefore, if the spread hits a credit Rs.33 the position would have been squared off. When market closed at 3:30pm, Nifty did not close at 9000, it closed precisely 59 points below 8700 and rendered the call premium zero. This is yet again an open ended question you want to ask yourself before executing a trade; do I want to make my own assumptions and risk it all, or should I follow market determined inputs with a crisp stop loss to trade options. The answer will determine how you evolve as an option trader in the days to come.