The 3 most critical aspects that can help option buyers generate consistent returns is a trending market, optimum volatility and the selection of strike. So, why do option buyers find it difficult to generate profits in the market? In today’s article we shall discuss, how option buyers can manage risk and smartly trade options that are likely to end in the money at a low cost and hold their positions without emotional drag.
Picture Source - Telgu Good Returns
Adopting Contra Approach
We all know that Bank Nifty Future closed at 51,661 on Friday. On Monday, when market opened 400 points gap down, none of the OTM Puts from 51,000 and down made a new high. Wonder why that happened? Smart money were not bothered covering their puts and post that we get 1,600 pints rally in two days. Now, you can either buy a call or sell a put option around the same area. At the time, of buying the option, there are two questions you must ask yourself, “Do I have control over the market trend or the volatility?” The honest answer is “No”. This also means that you are exposed to 2 major unknowns. So how should you handle this risk?
3D Delta profile clearly showed presence of buyers on 19th June and today (25th June). See the blue circles. What confused the retailers was the last 4 days sideways move. Where call sellers weren’t giving up but Monday's gap down made it all clear.
Selecting Option Strikes
Most Option buyers have a directional bias and are attracted to strikes with low premiums. Market makers on the other hand are direction neutral and know the art of buying strikes which are very likely to end in the money. Imagine you buy a Call option worth INR 100 when Bank Nifty is trading at 51,500 approx. and your stop is @ INR 55. So your investment is INR 100/ lot and risk is INR 45. Now imagine a situation where you are allowed to buy the same Call option at INR 40 when Bank Nifty is at 51,500 on the same day. The important question is, “Can this really be done”? The answer is “YES”
How to reduce The Cost of Investment
Here is what market makers do. They will buy the same Call option strike @ Rs.100, and look for another Call strike with an implied volatility that can help them negotiate sudden expansion in market volatility and reduce the cost of investment. Once they identify the IV, they will sell the newly identified Call option. Let us assume that the strike they bought was worth Rs100 and sold was worth INR 50. Thus, if they sell 1 lot, the total investment would now stand at Rs, i.e. {100-50}. This creates a perfect hedge for them as it gives them additional protection from theta decay as they have bought a Call option worth INR 100 at INR 40. Now the market maker has capped his total risk to INR 40 and given the market enough time to achieve the target. This is exactly opposite of naked option buying with a stop loss of INR 45, that can be triggered the same day.
What we also know is, the value of the spread cannot become zero till the contract expires. This allows them to hold the position over a longer time and a fixed risk of INR 40. We also need to keep in mind that the stop cannot be triggered until the last hour of expiry. To take advantage this process in live market, they follow a simple process. First identify the strike that you want to buy, and then find a strike with optimum IV that will absorb sudden shocks in market volatility and at the same time neutralize the rate of theta decay. This reduces the cost of buying an Option worth INR 100 by 60%. This is what allows the market maker to generate a steady profit even if the market takes some time to achieve their designated target.
Live Example
In the same contrast Bank Nifty trade was initiated by buying 26th June 2024 contract 51,900 CE at INR 207 and 52,100 CE was sold at INR 138, thus creating a simple bull call spread in the ratio of 1:1. The spread was bought at INR 63 and squared off at INR 154. Couple of puts were sold as a part of trending trade by selling 51,400 PE at INR 465 and covering at INR 250. The same put closes at INR 34 today.
Trade 1
Trade 2
