India’s most volatile, Bank Nifty plunged 500 points intraday after opening 1551 points gap down at 46,574 on 17th January, 2024. The index had been trapped in a range of 1,400 points since the 15th December 2023 as institutional traders had built ratio spreads in the options market. The important question is, what triggered 17th January's and today's fall?
The Ratio Unwinding
Between the 10th January and 16th January 2024, Bank Nifty had climbed 1,300 points. In the same time frame, institutional traders had created ratio spreads in options and forced Bank Nifty to slip into a narrow range. What is more interesting is, they went long in Vanilla Call options on the 10th of January to ensure that the market does not fall. On the 16th January, the institutions squared off the vanilla positions in Call options. This was the smart move which magnified the profits in the ratio from 150% to 198% at the close on the 16th.
On the 16th of January, profits from the ratio climbed to 117% and the first round of profit booking was initiated in the ratio. Bank Nifty slipped 300 points in the 2nd half of the trading session on 16th January. To be precise, 23% of the total ratio was covered. So why did it take 5 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 on 17th January and Today (Intra Day).
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 Bank Nifty tanked 2,060 points on 17th January after 20 days of range bound movement. Since the remaining 77% of the ratio was wrapped up, it ensured that the call option generated whopping returns intraday. In same contrast we sold Bank Nifty 47,600 CE at INR 152 on 17th January 2024 and covered today at INR 72.
Traders need to keep in mind that last two days downside was triggered by the unwinding of ratios and Institutional seller entering. Moreover, it was an expiry day and theta decay will speed up as we get closer to the expiry. Therefore, institutional sellers must enter the market on Wednesday for selling to continue (Like today) . A bounce-back can happen if institutional buyers enter the market next week or short covering is initiated. Let's not forget that 17th January’s and today's fall has already triggered an exponential expansion in the Put options intraday.