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How Option Buyers Can Avoid Traps?

In a surprising turn of events, India VIX has witnessed a jaw-dropping plunge to the current low of 8.125. The sharp fall in India VIX has landed a fatal blow on Put option buyers. Massive meltdown was triggered in Put options in the 22nd June weekly contract as Bank Nifty zoomed up. So why did Put option buyers get trapped? The answer is very simple; they ignored warning signs from the recent drift in market volatility. They were busy identifying a contra trade. Volatility drift is extremely powerful. It can speed up or slow down the rate of theta decay in options. In today’s article, we shall discuss how we can avoid these traps.

Step 1

Understanding the volatility adjusted market movement is more important than catching the trend from the chart. Since the trend on the chart does not incorporate the theta decay of the option strike or the drift in the volatility of the underlying instrument, the chart is the tool that leads option buyers into the trap. However, understanding the behaviour of the option gamma due to the shift in market volatility gives you a super advantage. Imagine I ask you “how far can you drive your car based on the gas in the tank”? To answer this question, you need two inputs only, how much gas do I have and what is the mileage of my car, it’s that simple. Here too, you are not buying options based on the trend; you are simply tracking how far the market can rise based on the underlying volatility. The inputs, you need is drift in market volatility and the valuation of the Call option strike. Therefore you are never going to fall into the trap, period! Step 2

Always keep in mind that option premiums of any underlying instrument never follow linear volatility distribution. So what does this mean? Let us take a live example, take a look at the 43,500 call option in the June 22nd contract. The 43,500 call option was trading around 150 when Nifty registered a low of 43,345 on Wednesday. If the market obeyed linear volatility distribution the Vega adjusted demand curve in the Call option should have neutralized the rate of theta decay. However, when we evaluated the 43,500 call option by using the terminal volatility matrix, it was an open and shut case. The strike was clearly undervalued even when it was trading at 150. The next step is to follow the thumb rule, always buy undervalued options. If you were looking at the chart, you would never think of buying the 43,500 call option when Bank Nifty spot was 43,400. This is exactly what we call a trap. Most retail traders would sell this call seeing bank nifty breaching below last 3 days low which was an important support for chart traders. Step 3 – Execution

The 43,500 call option was bought at 154 on Tuesday. About 80% of the position was covered, when the call zoomed to INR 384 the same day. Exit is very vital in buying options.

What is most important is, we were buying a Call option during a falling market by calculating the volatility adjusted market movement. We were not interested in predicting the market and buying Put options. So can this method be applied to selling options also? The answer is, “Yes”. Whether the market rises or falls sharply, the risk was very small because you would buy undervalued options and sell overvalued ones. In our case, option buyers had owned the risk by buying the 43,500 Call which was trading way below its fair value threshold, therefore the only solution was to buy the Call and watch it rally like Usain Bolt.

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