While trading Bank Nifty options traders generally ask three questions, “What is the trend”?, “What strike should I buy”? and “Where should I execute the trade?”. Option traders know that Bank Nifty undergoes huge swings and big money can be made. The last line states something very important. It says, you can earn big, as Bank Nifty undergoes huge swings. In other words, if you can calculate the volatility adjustments, you can hit the jackpot.
This is exactly how hedge fund models are designed. There’s no doubt that Bank Nifty is a money making machine. In today’s research report we shall bust the myth around trend and deal with Bank Nifty options with the help of volatility. We shall leave you with 4 steps that can help correlate between options strikes and the underlying volatility.
Take a neutral approach and study Bank Nifty’s behaviour. If you look closely, you will notice, Bank Nifty had undergone incredible swings in the past few sessions. The index had dropped sharply by 2000 points from the recent high of 21100 and then bounced back more than 1000 points from the recent low of 19002. Given such volatility, does it makes sense to look for trend? The answer is ‘NO’. Trending markets obey uniformity of direction, the recent moves was very choppy. Therefore rather than asking what is the trend, option traders should focus on the volatility drift in the instrument.
Are you an option buyer or seller? Take for example you want to buy and hold an option for the next 4- 5 trading days, or you want to sell and hold for few days. First you must derive the volatility drift based on (St > K) & (K > St ). This decision is very critical. To execute trades based on volatility, you would need to combine the two most important aspects. First the volatility adjusted range of the instrument and second, selection of strikes in that range. If you are option buyer, you pick up undervalued strikes. If you are a seller you deal with the overvalued ones. Now notice that we are not focusing on the trend at all. Here we know the maximum range where (St > K) nullifies the volatility adjusted risk. So you must choose the strikes Ck and Pk accordingly. Ck denotes the Call strike and Pk denotes the Put strike at discreet time “t”, where St is the price of Bank Nifty.
What is the current volatility? To answer this question, you would require a model that can capture the volatility drift during live markets. We use Terminal Volatility to determine the same. Hedge funds generally have their own. Now this is not a simple formula which you can punch during live markets because you are dealing with a volatile instrument and we have your limitations as humans. This is where most impurities are filtered. The buyer picks the undervalued strikes, while the seller grabs the overvalued ones.
Take for example today, Bank Nifty opened at 19800 in the morning. Based on Terminal Volatility adjustments the 20000 Put and 20100 Call option was identified. Notice at 9;43 am St is at 19797. In today’s situation, if you were an option buyer, you would buy the 20100 Call option around Rs.64 as it was undervalued. While the 20000 Put could have been sold by the option seller around 360 it was over-valued. The most important thing to notice here was, terminal volatility adjustments was indicating to buy a Call or Sell a Put. Based on our risk evaluation model we sold the 20000 Put @ 350. The short position was covered at Rs70, but was rendered worthless at the end of the day as the equation (St > K) was a perfect match. For those who are wondering what happened to the Call? It closed at Rs.165 at the end of the day proving yet again that the 20100 call option was indeed undervalued at 9:43 am. Since Bank Nifty closed above 20100 the equation (St > K) was also a perfect match here.