If you have been a trader for 6 months, you must have heard about contra trades. In today’s research report we shall talk about “Contrarian Option Trading”(COT). COT is a powerful Alternative Investment Technique. This method is sleek and is very powerful as it uses the volatility adjusted time decay of options to determine fair value of a strike. Contrarian option trading is known for its pinpoint accuracy and provides a strong edge for option buyers. When you are buying options with a small premium, your investment is extremely small, compared to the option sellers large fixed margin. Imagine you buy 4 lots of option in Nifty @ Rs 25, with a volatility adjusted risk of Rs.10. Here your total investment is just Rs.7,500. Then you sell the position @75 intraday. Your net profit is Rs.15000, on a risk of Rs.3000. The important question is, what is “COT” and what are the advantages of this tool? Simply put, COT is a volatility adjusted price band in Nifty where specific Call options become dangerously undervalued during a falling market. While specific Put options are dangerously undervalued during a rising market. The advantages are.
- COT requires extremely small investment
- RR ratio is very attractive
- Targets are achieved the same day
COT Is A Function Of Weekly Option Contract
We all know that every Nifty futures contract has 4 different weekly option contracts. This is exactly what COT takes advantage of. It identifies the undervalued option strikes at discreet time “t’ based on the volatility adjusted fall or rise in Nifty during the specific week. So what does this mean? To simplify this, let us imagine you are at the park observing 4 kids playing on a swing. Now imagine each kid sat on the swing and someone pushed the swing with the same force every time. You started noting down the number of oscillations before the swing came to rest. What you will notice is the number of oscillations will be different for each kid, although the push force and the swing is the same. The important question is why does this happen? The answer is simple, the total number of oscillations of the swing, depends on the weight of the kid and the contra force of wind at the time. Now let’s apply this mathematics to the Nifty options. In Nifty the futures contract is the same and the underlying volatility is the same. But the 4 weekly contracts are like those 4 different kids. Each of these weekly contracts will have its own COT zone depending on its volatility smile.
Identifying The “COT” Zone
The first step is to identify which option strikes are undervalued when Nifty enters the COT zone. We use Terminal Volatility to extract this data. You can also use the covariance of the vega and the theta based on the volatility drift of the underlying instrument at discreet time ”t”. Once the strike is identified, the rest is simply plug and play.
The Live Example
Take for example, today’s scenario, Nifty opened at 9214 in the morning and then plunged 90 points to a low of 9125. Terminal volatility calculations indicated that Nifty had entered the COT zone once it dropped below yesterday’s low of 9190 and touched 9163. A COT zone is the area where specific Call options become dangerously undervalued in a falling market and specific Put options are dangerously undervalued in a rising market. The next step was to identify the call strike. Since the extreme end of today’s volatility smile was 9400, we bought the 9400 Call @ Rs. 22.50. Thereafter the market bounced sharply by 250 points and registered a high of 9375. This up move has nothing to do with the trend, 9400 call went on to register a high of Rs.85 because it was heavily undervalued when Nifty entered the COT zone. The position was later covered @75. The two most important aspects you want to notice here is that the Volatility Smile helped us to identify the 9400 call. This ensured that we had a very small risk of Rs.22. The COT zone helped us take a contra long trade in the 9400 Call option despite market plunging 90 points and breaking its previous day’s low of 9190. This is why Hedge Funds use these Alternative Investment Techniques while retail clients are mostly foxed by the technical charts.