Since option premiums derive their values from the movement of the underlying instrument, adjusting the market volatility is extremely essential when market uncertainty drives India Vix to levels of 72.Take for example today’s situation. Nifty opened 300 points gap down at 8111 and slipped 300 points, to a low of 7816. Thereafter the index bounced back 700 points and registered a high of 8531. In a situation like this, when Vix is at 73, it is extremely easy to get trapped trying to capture the trend and trade a single call or put option.
Credit Vs Debit Spread
In a recent article “How To Trade Nifty Option When Vix Is High” we had discussed a similar situation where the Call option buyers got lured into a trap on Monday after market bounced 700 points after the trading halt. In order to understand the Vol spread, we must get a fair idea of how a credit spread is different from a debit spread. Take for example you buy a Call option @30 and sell another Call option @ 150. It is a credit spread because you have received Rs.120 by creating this spread. It is important to keep in mind that, theoretically the maximum gain in a credit spread is limited to the premium you have received. Whereas if you buy a call @150 and sell another Call @30, it is called a debit spread because you paid Rs.120 from your pocket. In the case of a debit spread the profit is theoretically unlimited.
Volatility Adjusted Spread
On Wednesday towards the last half, when Nifty futures failed to break its previous low of 8299 and bounced back, we bought the 9100 Call option in the 26th March contract @172 and sold the 9200 Call option in the 26th March contract @146. This looks like a conventional Bull call spread executed at Rs26. It is important to keep in mind that when we were executing this spread, India Vix was at 63, so we knew very well that we were entering a high premium trap. Therefore we had to neutralize the excess Volatility premium. The Terminal volatility gauge was used to identify a strike that would hedge the position. We sold 4 lots of 8900 Call in the 19th March contract @ 38. To the naked eye this might appear like a typical credit spread with a pay-in of Rs.126, but it is not.
Managing Market Volatility
Today, Nifty opened 300 points gap down and India Vix spiked up to 73. The credit spread was reduced to zero. The position was covered when the spread was at “0”. We bagged the full volatility premium of Rs.126, because as theory says, that was the maximum we could earn. If you were holding the spread till day end, it would have fetched you Rs.162. Theoretically the maximum profit for the option seller is limited to the premium sold, in this case Rs.126. If you look closely, you’ll notice all the bookish theory changes when the volatility is abnormally high. Therefore it is important to note that you can trade options with intelligently crafted spreads even when India Vix has spiked up to 73.