If you are a Bank Nifty options trader, you are certainly aware of what volatility is. However, the moment someone asks you to apply the same concept and trade Bank Nifty options, you are lost. In today’s article we shall look deeply into this seemingly complex topic and come up with an easy solution. We shall also provide a live trade to make life easy.
We all know that Bank Nifty undergoes huge volatility shifts on a daily basis. So what does this actually mean? Theoretically volatility can be defined as the standard deviation of the return provided by a stock in one year. This is where things get interesting, you must understand that volatility in options is not the same as volatility in the equity market. The important question is why? The answer is simple, stocks do not undergo theta decay with the passage of time when markets witness low volatility. This is exactly why option trading requires a keen sense of understanding of the how the greeks are correlated. In this case, the relationship between volatility adjustments and theta decay. This concept is immensely powerful and works like magic for instruments like Bank Nifty options. For ease of understanding we shall break it down to 2 steps. First we shall look into the theta decay progression and then correlate it with volatility.
Observe Bank Nifty’s behaviour from a neutral stand point on the 14th of July 2020. If you look closely, you will notice, Bank Nifty had undergone incredible swings. The index had plunged 732 points in a single day. Given such volatility, it is quite obvious that put option buyers would have bought OTM strikes in Bank Nifty. If this is true, then there would be specific put strikes that are heavily overbought. At this time it is important to calculate the volatility adjusted theta drift and identify the put strikes that are over-valued.
Think like an option seller. Take for example you want to sell a put option when Bank Nifty had fallen more than 700 points and hold it over -night. You certainly would need to ensure that the option you are selling is heavily over bought. Why is identifying an overbought option so important? This step will ensure that that market makers will dare not build long positions in that strike at all. Thus, stay focused on the fair value of the option and find out the volatility adjusted market movement. When Bank Nifty plunged 732 points on the 14th, we used volatility adjustments together with the theta progression and found out that the 21300 Put was heavily overbought. Keep in mind that we are simply correlating the options theta progression with respect to the shift in the vega component. Thus the 21300 Put was sold at 286 on the 14th of July. If you look closely, you will notice, that Bank Nifty opened more than 200 points gap up around 21645 today (15th July). The question is why? Well you should have guessed it by now, the market makers simply ate up the excess valuation in 21300 Put option. The 21300 Put option melted away like ice-cream under the hot sun. We closed our position at Rs.73, netting a total profit of Rs.213 per lot.