High volatility in Bank Nifty often causes irregularities in option pricing. This is perceived as a hurdle by most option buyers. However, if you look closely you will notice Bank Nifty creates more opportunities for option buyers who ignore the trend and focus on the volatility. Bank Nifty has a small lot size, hence the risk from exposure is very small, plus, the index undergoes huge volatility almost every day. Therefore the risk for an option seller is relatively high in Bank Nifty. This is one reason why option sellers often avoid selling far OTM strikes. These strikes have the possibility to multiply 5x, 10x or more very “Quickly” because volatility adjustments play a very critical role in determining the premium of an option strike in Bank Nifty.
Option pricing And Volatility
Let’s take for example, I buy a Bank Nifty call option worth Rs.20. Step one is the most critical aspect. I need to find the volatility adjusted market movement with the help of terminal volatility. So what does this mean? Here I do not need to know the market direction. I am using the volatility curve as a spring board to find out how far OTM an option can I buy. Imagine a frog waiting to catch an insect. The frog is fully aware, how far it can jump. Based on this data point, the frog needs to adjust to the position of the insect.
This is where the role of option valuations come into play. In our previous article “How Option Buyers Can Avoid Traps” we have discussed in detail the impact of volatility on option premium and how we had sold the 9300 Nifty Call option based on option valuation. If you had been tracking the market in the last few days, you will know very well, that Nifty failed to cross 9300 despite climbing till 9282. Always remember, whenever you are trading a volatile instrument, option valuation offers you the strongest edge. Thus in today’s article we shall discuss a real volatility adjusted Bank Nifty option trade that can help the option buyer spot the right strike at the right time.
Volatility Adjusted Option Behaviour
So what is volatility and why is it so critical for option buyers? Many times in the past we have stated that option premiums are mostly driven by emotions in the traders mind. These emotions are often classified as demand & supply in conventional economics. However if we apply terminal volatility we can streamline the shift into a clear range or distinct a price band. It works accurately to pin point the extreme ends of euphoric buying or panic selling. Once you identify this price range, the market direction does not matter. You spot the OTM option in that range based on your risk and go for the kill.
The Trade Execution
Take for example today’s situation, Bank Nifty did not display any direction as it fell from 18700 in the morning and made a low of 18661. In such a situation, looking for a trend is a waste of time. Here we are looking to analyse the volatility adjusted market movement. Therefore we used terminal volatility to gauge how far Bank Nifty options could jump or drop. Next we checked the theta adjusted valuations to spot a call and put strike in that range that was undervalued and was within our risk appetite. The 19300 Call option was a perfect match, however, the subsequent Put strike in the volatility range did not meet the criteria. So we bought the 19300 Call option @ 39 around 9:30 am in the morning. Since our entry was @ 39 based on the valuation, the risk was also Rs.39. Throughout the first half, Bank Nifty remained volatile. In the 2nd half, the 19300 Call option started climbing and registered a high of Rs.190 which is 6X from the low of Rs30. The Call option was later squared off at Rs. 123. Even if you were holding the Call option till the end, you would notice that the 19300 Call option registered a low of Rs.9 around 2pm and then again bounced back to Rs.115 and closed at Rs.100. This is the level of accuracy of volatility adjusted option valuation. There are two choices we have as option traders. Either we use the tools intelligently and spot the opportunities to make it to the top 5%. Or be a part of the bottom 95% looking to spot the trend from the charts thus fail to identify the big opportunities.