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In a surprising turn of events, India Vix has witnessed a jaw dropping plunge from its recent high of 83 to the current low of 49 in matter of days. The sharp fall in India vix has landed a fatal blow on Put option buyers. Massive melt down was triggered in Put options in the 9th April weekly contract as Nifty zoomed up. So why did Put option buyers get trapped? The answer is very simple, they ignored warning signs from the recent drift in market volatility. They were busy identifying a contra trade. Volatility drift is extremely powerful. It can speed up or slow down the rate of theta decay in options. In today’s article we shall discuss how can we avoid these traps.

Step 1

Understanding volatility adjusted market movement is more important than catching the trend from the chart. Since the trend on the chart does not incorporate the theta decay of the option strike or the drift in volatility of the underlying instrument, the chart is the tool that leads option buyers into the trap. However, understanding the behaviour of the option gamma due to the shift in market volatility gives you super advantage. Imagine I ask you “how far can you drive your car based on the gas in the tank”? To answer this question, you need two inputs only, how much gas do I have and what is the mileage of my car, it’s that simple. Here too, you are not buying options based on the trend, you are simply tracking how far market can rise based on the underlying volatility. The inputs, you need is drift in market volatility and the valuation of the Call option strike. Therefore you are never going to fall into the trap, period!

Step 2

Always keep in mind that option premiums of any underlying instrument never follow linear volatility distribution. So what does this mean? Let us take a live example, take a look at the 9300 call option in the April 9th contract. The 9300 call option was trading around 89 when Nifty registered a high of 9144 on Wednesday. If the market obeyed linear volatility distribution the vega adjusted demand curve in the Call option should have neutralized the rate of theta decay. However when we evaluated the 9300 call option by using the terminal volatility matrix, it was an open and shut case. The strike was clearly overvalued even when it was trading at 55. The next step is to follow the thumb rule, always sell overvalued options. If you were looking at the chart, you would never think of selling 9300 call option when Nifty future was 9144. This is exactly what we call a trap. Most retail traders would buy this call. We had discussed the steps in our article “How Option Buyers Must Choose the Strike”.

Step 3 – Execution

The 9300 call option was sold @ 55 on Wednesday. About 80% of the position was covered, when the call dropped to Rs.8 the same day. The rest of the 20% was carried forward, along with a hedge. Today the 9300 call option in the 9th April contract closed at zero. What is most important is, we were selling a Call option during a rising market by calculating the volatility adjusted market movement. We were not interested in predicting the market and buying Put options. So can this method be applied to buying options also? The answer is, “Yes”. Whether the market rises or falls sharply, the risk was very small because you would buy undervalued option and sell overvalued ones. In our case, option buyers had owned the risk by buying the 9300 Call which was trading way above its fair value threshold, therefore the only solution was to sell the Call and watch it melt like ice-cream under the hot Sun.