India’s benchmark Nifty Futures plunged 240 points intraday after opening 30 points gap up at 11636 today. The index had been trapped in a range of 232 points since the 10th of July as institutional traders had built ratio spreads in the options market. The important question is, what triggered today’s fall?
The Ratio Unwinding
Between the 10th and the 17th of July, Nifty had climbed 226 points. In the same time frame, institutional traders had created ratio spreads in options and forced Nifty to slip into a narrow range. What is more interesting is, they went long in Vanilla Call options on the 16th of July to ensure that the market does not fall. On the 17th July, the institutions squared off the vanilla positions in Call options. This was the smart move which magnified the profits in the ratio from 50% to 98% at the close on the 17th.
Yesterday, on the 18th of July, profits from the ratio climbed to 117% and the first round of profit booking was initiated in the ratio. Nifty slipped 75 points. To be precise, 23% of the total ratio was covered. So why did it take 7 trading sessions for the ratio to generate 117% profit? The ratio was primarily designed to eat up the time value of options, thus it can only yield profits after the time decay is complete. As traders, we can use, one of the two approaches, either build a ratio with the institutions and hold for options theta to melt (Positional Trade). Or wait for the swing after the ratio is wrapped up and then enter the market. In the 2nd case, we are allowing the gamma of the option to expand very rapidly, exactly what we witnessed today (Intraday Trade).
What Did We Learn Today
What we learned today was very significant. Although we know that the gamma and Vega in a volatility spread are comparatively weaker than the conventional straddle or strangle, option buyers must wait till the ratios are wrapped up for sharp expansions in premiums. It is not surprising thus that Nifty tanked 240 points today after 7 days of range bound movement. Since the remaining 77% of the ratio was wrapped up, it ensured that the 11500 & 11400 Put option generated a whopping 740% and 1260% return intraday.
Traders need to keep in mind that today’s downside was triggered by the unwinding of ratios. Moreover, only 4 days are remaining in the July contract and theta decay will speed up as we get closer to the expiry. Therefore, institutional sellers must enter the market on Monday for selling to continue. A bounce-back can happen if institutional buyers enter the market next week or short covering is initiated. Let’s not forget that today’s fall has already triggered an exponential expansion in the Put options intraday.