We are all aware of choppy markets. It’s the kind of market that doesn’t have a defined direction. The current Nifty September contract is a perfect example of a choppy market scenario. September contract opened at 11006 and plunged to 10785. Thereafter it registered a high of 11118 and again fell more than 300 points as it hit a low of 10807 today. The important question is how professional option traders trade such choppy markets. The answer is, they build Positional Option Spreads. The question is how can we create these Positional Spreads at a retail level? To find out, first let us understand what option spreads are.
What are Spreads?
One of the most lucrative methods of option trading is by building ratio spreads. A spread is an intelligently crafted option sequence which involves two or more options of the same type. In practice, spreads have two legs. One leg is created to generate returns, the other acts as a protective cover. Take for example a trader is long one lot of 11200 call @ Rs30 and shorts 2 lots of 11400 call @ Rs10 each, at time ‘t’. To execute this options sequence, the trader pays Rs.30 to buy one lot 11200 call and receives Rs.20 by selling 2 lots of 11400 call. The net value of the spread therefore is Rs(20-30)= Rs-10. This implies that there is an investment of Rs10 in this spread for the trader. So what is the advantage of creating a spread and how does one choose the strikes? These questions, we shall address later in the article.
Positional Spreads have two unique characteristic, firstly they are designed to be direction neutral. This means the trader has the advantage of holding his position irrespective of the trend or market volatility. Let’s keep in mind that this spread starts with a net pay-in, therefore the coefficient of covariance between the vega and theta should be placed intelligently to offset all kinds of premium expansion due to volatility spurts.
Look at it this way, there are 4 participants A,B,C,D in 400 meters race. A, is standing in the inner most lane and D is starting from the outermost lane. You’ll notice that D’s starting point will always be ahead of “A”. This is simply because the organizer wants to offset A’s undue advantage over “D”, caused by the shorter inner circumference.
In other words, the our spread needs to be crafted in such a way that the pay in from the theta premium can offset the payout from the vega premium even if the market is hit with excesses volatility due to an event or news. This explains the sheer advantage of the Option Spread Trader under all market conditions.
How To Identify The Strikes
Consider a situation, where your position needs to be trend neutral. We all know that trending markets causes the option premium to rise. This implies that during a trending market the options gamma must expand and the IV of the option must offset the theta decay.
Now let’s turn the situation inside-out. Let us assume that we want to remain trend neutral. We want our position to float alongside the market and ensure that it bags the constant theta decay as time passes by. This is where we need to meticulously calculate the forward sigma for the contract as it drifts closer to maturity. In theory volatility is independent of the time to maturity. However, Positional Spreads for all practical purposes are driven by the coefficient of covariance between the Vega and the Theta of the spread. Therefore what we need to solve this by establishing a sequence of strikes that will generate the perfect balance to offset the uncertainty for the month. So deal with it one step at a time. First, work on determining the forward sigma factor. Then establish the theta decay. The last step is to derive the coefficient of co-variance between the theta and vega to identify the strikes. The rest is about waiting for the premium to melt away with time.