Most option traders are eager to trade during or before an event. This is a common phenomenon because, option premiums expand rapidly during events and the ROI is extremely high. However you must be spot on with option valuation and precise in your timing when you are trading an event. Take for example today’s RBI policy, Nifty opened up a wide range of trading opportunities as the market witnessed extreme volatility. In today’s article, we shall discuss how option traders can profit from such volatile markets.
The Importance Of Option valuation
There are several factors that cause option valuation to change. Volatility is one of the most important factor amongst them. You will notice, traders are mostly focussed on predicting the outcome of an event. They hardly ever look into the fair value of an option strike based on the volatility curve triggered ahead of the event. Take for example today’s RBI policy, at the back of your mind you are thinking, I will buy a call if the RBI cuts rates, else I shall buy a put. The truth is most traders do not know whether the RBI will cut the benchmark rates or will raise it until it is announced. If you look closely you’ll notice that the market either spikes up or plunges down, moments before the news is flashed on the TV screen. The question is can option traders capture this sharp move before the result is out? The answer is “Yes” The trick lies in understanding the fair value of an option strike. In most cases we use terminal volatility to find out the volatility adjusted market movement. This helps us establish options that are either overvalued or undervalued. Thereafter trades are executed based on the volatility adjusted option valuation much ahead of the event. This method is sleek, sharp and very simple to execute. You either sell the overvalued strike or buy the undervalued strike depending on the risk component. The question is how can you use this method during live market? To solve this, let’s take a look at today’s execution.
Trade Execution based On Valuation
For ease of understanding, let us consider today’s example. What we did was simple and can be replicated by retail clients also. First we checked the opening price of Nifty futures today. We know that Nifty Futures opened at 11140 in the morning. This means 11150 Call and Put were the ATM strikes based on today’s open price. Terminal volatility calculations indicated that the 11150 Put in the 6th August contract was highly overvalued compared to the 11150 Call in the same contract. This meant we could either buy the 11150 Call or sell the 11150 Put for the 6th August contract.
We all know that the rate of theta decay speeds up on the last day of any expiry. Since today was the last day of the 6th August weekly contract we chose to sell the 11150 Put option rather than buying the Call option. Thus 2 lots of the 11150 put was sold @ Rs.40 around 9:30 am. Since the RBI policy was scheduled at 12pm today, we knew that Nifty might be hit with heavy volatility. Thus we used terminal volatility calculations to identify an undervalued Put option in the 13th August contract to hedge our sold position. Based on volatility adjusted valuation metrics, 1 lot of the 11100 Put option in the 13th August contract was bought @97. What you just saw was a volatility adjusted calendar spread created based on option valuation. The position was opened at 9:30 am, buy 1 lot 11100 Put 13th Aug @ 97 and sell 2 lots 11150 Put 6th Aug @ 40 each. The spread was initiated at Rs.17 (97-80). After the RBI policy was announced, the spread zoomed up to Rs.52 around 12:27 pm. Due to the pin point accuracy of the option valuation, the spread generated a whopping 205% return on the invested value in 3 hours flat, despite the high volatility triggered by the RBI Policy. This yet again proves that it is important for option traders to focus on the option valuation at all times, as it is possible to calculate the valuation but not the outcome of the event.