Since our post on LinkedIn and our newsletter on 5th June, Bank Nifty Future has registered fresh highs (44,545) on three different occasions but has failed to sustain the buying momentum. The most recent one being today. Most of us want to know why? We shall get to the bottom of this question in today’s article.
Volatility Outlook
For ease of understanding, we shall look into Bank Nifty futures and Call option premiums. If you look closely, you’ll notice that in all the three instances when Bank Nifty had registered all-time highs, Call options were nowhere near the highs (Analyse 44,000 CE to 44,400 CEs). On charts you see breakouts and you buy call option without analysing how smart money has placed himself. Option traders know that VIX is a reflection of the extent of volatility in the underlying market. However, they often misunderstand low VIX as premiums being balanced. This is exactly where things get interesting.
VIX vs Option Premiums
It is important to understand that India VIX incorporates the statistical shift in OTM option premiums with respect to the change in the price of the underlying asset. So let us look into what the exchange does to extract VIX from the open market. First, the exchange uses the variance of the near contract and the mid-contract separately. The variance is then interpolated to get a single variance adjusted to expiry. The square root of this variance is then multiplied by a factor of 100 to arrive at India VIX. Therefore it is fair to conclude that the premiums of every strike on the option chain will not maintain a linear correlation with India VIX. Thus as option buyers, we must closely monitor the expansion or contraction in implied volatility of specific strikes and not VIX per se. This will help us gauge whether the strike should be bought or sold.
Decoding the fall
Now let us look into this week’s movement in Bank Nifty. It is very important to note that, institutional buyers were not active in Bank Nifty around the highs of the index. FOMO buyers were entering but were not able to give a comfortable close but sellers also weren’t entering in confidence. On Wednesday (7th June) bank nifty made a new high for that week but call premiums were nowhere near the highs and puts were making new low. Here we must ask why they were not active. It is because Call option premiums were excessively high despite index making new highs, call sellers were not breaking any sweat.. The question is how do we know that call options were expensive? We combined the 3D Delta software with the terminal volatility gauge to measure the 44,200 call strike. If call options are expensive, it also means that smart money was expecting downside moves. To test the sequence, we sold the OTM call option of 44,200 strike @ 40 despite the absence of institutional sellers and the call option being overloaded with unnecessary premium. Smart money went all out with their call short. Thereafter Bank Nifty witnessed a fast downside fall of another 264 points and the 44,200 CE was covered at an average of 11 and later the same call expired 0 and mind you, this trade was only for 5 minutes.
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