When an option buyer enters the market, he simply wants to identify the trend. In most cases, there are two reason behind this thought process. First, the option buyer want to determine whether he should buy a call or a put option. Second he wants to generate 5X or even 10X return by deploying a very small capital. Take for example, Nifty is trading at 8700, and he has observed that the market has been moving 400 points every day since the last 20 days. Thus he wants to grab the opportunity and make a killing. He wants know whether to buy the 8300 put option or the 9000 call option. With so many strikes available on the option chain, he is faced with one question, which strike should I buy?
Find The Edge
We must know where to look, if we want to find the edge. In today’s article we shall solve this challenge for the option buyer. First and foremost, only buy options which are under-priced, never ever buy an overpriced option, no matter what the trend. The obvious question is why? This is because, option sellers sell overpriced options all the time. This is the same phenomenon used by hedge fund managers when they create a spread using multi leg options. They buy the under-priced option premium and sell the overpriced strike. Now imagine what retail traders do, they look for premiums according to their trading capital. They are focussed on generating 5X return on the investment. Therefore their long positions in an overvalued option strike stands no chance because it is the same strike the hedge funds have sold in huge quantity. So, rule number 1 is calculate the fair value of the option strike, before you buy it. If you can do this, you will be surprised by the results, because that is where the hedge funds are sitting and they will protect their positions by all means.
Step 1- Calculate The Fair Value
We know that an option can either be at fair value, overvalue or undervalue. As a rule of thumb, comparing the shift in the volatility of the underlying instrument is a must, when comparing this value. This mean, when you buy an option, you must incorporate the drift in the volatility of the underlying. While buying an option you are exposed to a certain percentage of the theta component. You don’t have a choice because all options have a time value component. If the drift in volatility is positive, then the theta will expand and cause the option to be overvalued in certain strikes, however, if the drift is negative, then valuation of those certain strikes might drop below the fair value. At first glance, an option strike trading at Rs.30 might seem at fair value compared to another option with a premium of Rs.130. Never make this mistake of comparing 30 with 130. When calculating the fair value, always compare the impact of the drift in volatility in both the cases.
Option buyers generally fail to make money either because they have not picked up the right strike, or they did not book the position at the right time. If you have not picked the right strike, then follow step 1 and correct that mistake. If you are successful in identifying the right strike but losing out because you are not booking profits, then there is a separate solution for you below.
The Profit Booking Solution
Those who do not understand where to close a winning trade, they are generally assuming that the 5X profit will explode and become 10X. In general most option buyers think they have acquired immunity against volatility once the position is in 3x profits. So what should you do to avoid this trap? Always keep in mind that India Vix or volatility is continuously changing even if the trend is on your side and the position is in profits. Since the option theta is very sensitive to the change in volatility, option buyers must always stay one step ahead of the curve. As a buyer you are dealing with the time component, therefore even if the strike you have bought is currently deep ITM, even a miniscule change in volatility can make or break your trade. As a profitable option buyer you must always evaluate the current premium of the option by adjusting the likely drift in the underlying volatility in accordance with the time till expiry. Remember the market maker is always keeping a close watch on the top bid and top ask of an option strike. The moment the bid ask spread expands or contracts beyond the realm of the existing market volatility, he will attack the strike with brute force. You want to book your profits before that happens.