How To Neutralize Option Mispricing In Nifty

Of all the different methods that are used to evaluate the fair value of an option premium, neutralizing the volatility premium provides the strongest edge. The obvious question is why? First, volatility does not follow any historical reference point. The second and the most important reason is, when you neutralize the volatility, it is real-time activity involving live data inputs. Hence it provides pin point accuracy in picking up strikes at the time of execution. In today’s article, we shall discuss what terminal volatility is & how it can be used.

What is Terminal Volatility?

In essence, terminal volatility is a tool that measures the speed of the market. We know that prices are driven by emotions in the traders mind. These emotions are often classified as demand & supply in conventional economics. However terminal volatility looks at these shifts as extreme confidence or extreme uncertainty. It works to identify the point where an option buyer has no point of return.

The Trigger

We all know that there was news of a $2 trillion Fed stimulus in the market. The Indian government was also planning to roll out stimulus packages. This is positive news and it added fuel to the call option buyer. This caused Call premiums to overheat. Today at 10:20 in the morning, when Nifty registered a high of 8750 the terminal volatility gauge spotted an exponential expansion in the 8700 call option in the 26th March contract. The call strike had already over heated and registered a high of 159. The terminal volatility gauge indicated that the buyers had reached extreme confidence.

The Execution

3 lots of the 8700 call were sold in the 26th March contract @109. But we had to neutralize the risk that could be triggered by a sudden rise in volatility. So we bought 1 lot of 9500 Call in the 30th April contract @319. It was a credit spread as we had received Rs.8 to create the spread {3x (-109)+1x(319)}=-8. The max risk in this spread was computed at Rs.25. This risk factor depends on the extent of overpricing in the 8700 strike call. When market closed today, the 8700 call was rendered zero and the 9500 call settled at 271. The spread value was at a whopping 271. The most important point here is, we did not know whether Nifty would be relatively volatile or relatively quiet today as it was the last day of the March contract. We simply neutralized the volatility and was prepared to take a maximum risk of Rs.25. The RR as you know was a nerve wracking 1:10, and the best part, you received premiums to create this spread. Interesting isn’t it?