Since our last article on “How Hedge Funds Trade Options”, Nifty has registered fresh highs on three different occasions but has failed to sustain the buying momentum. The most recent one being yesterday. Most of us want to know why? We shall get to the bottom of this question in today’s article.
For ease of understanding, we shall look into Nifty futures and India Vix around the same time frame. If you look closely, you’ll notice that in all the three instances when Nifty had registered all-time highs, India Vix had been hovering around 11-14 range. 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 From 12357
Now let us look into yesterday’s fall after Nifty touched 12357. Nifty opened a 20 points gap up around 12295 approx and made a high of 12316. It is very important to note that, institutional buyers were not active in Nifty around that area. Here we must ask why were they not active? It is because Call option premiums were excessively high despite Vix around 14. The question is how do we know that call options were expensive if Vix was at 14? We combined the 3D Delta software with the terminal volatility gauge to measure the 12400 call strike. If call options are expensive, it also means that traders were expecting massive upside moves. To test the sequence, we bought the OTM call option of 12400 strike @ 26 despite the absence of institutional buyers and the call option being overloaded with premium. When 12400 Call option crossed 33 our terminal volatility gauge was indicating that we must exit the Call. We squared the position at Rs.34.55. At this point, we entered the 12250 Put @53.50. Thereafter Nifty witnessed a fast downside fall and the 12250 put went on to make a high of Rs87. The Put option was later covered at Rs.70.
Nifty 12400 Call Option Trade
Nifty 12250 Put Option Trade