High volatility in Bank Nifty often causes irregularities in option pricing. This is perceived as a hurdle by most options buyers. However, if you look closely you will notice Bank Nifty creates more opportunities for option buyers who ignore the trend and focus on the volatility. Bank Nifty has a small lot size, hence the risk from exposure is very small, plus, the index undergoes huge volatility almost every day. Therefore the risk for an option seller is relatively high in Bank Nifty. This is one reason why option sellers often avoid selling far OTM strikes. These strikes have the possibility to multiply 5x, 10x or more very “Quickly” because volatility adjustments play a very critical role in determining the premium of an option strike in Bank Nifty.
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Option pricing And Volatility
Let’s take, for example, I buy a Bank Nifty call option worth INR 20. Step one is the most critical aspect. I need to find the volatility adjusted market movement with the help of terminal volatility. So what does this mean? Here I do not need to know the market direction. I am using the volatility curve as a springboard to find out how far OTM an option can I buy. Imagine a frog waiting to catch an insect. The frog is fully aware, how far it can jump. Based on this data point, the frog needs to adjust to the position of the insect. This is where the role of option valuations comes into play. In our previous article “How Option Buyers Can Avoid Traps” we have discussed in detail the impact of volatility on option premium and how we had bought the 43,500 Bank Nifty Call option based on option valuation. Always remember, whenever you are trading a volatile instrument, option valuation offers you the strongest edge. Thus in today’s article, we shall discuss real volatility adjusted Bank Nifty option trade that can help the option buyer spot the right strike at the right time. Volatility Adjusted Option Behaviour
So, what is volatility and why is it so critical for option buyers? Many times in the past we have stated that option premiums are mostly driven by emotions in the trader's mind. These emotions are often classified as demand & supply in conventional economics. However, if we apply terminal volatility we can streamline the shift into a clear range or distinct a price band. It works accurately to pinpoint the extreme ends of euphoric buying or panic selling. Once you identify this price range, the market direction does not matter. You spot the OTM option in that range based on your risk and go for the kill.
The Trade Execution
On Wednesday i.e. 23rd Aug 2023, post 12 PM, 44,400 Call sellers gave up and turned into buyers. Now, when situations like these happen, a minimum of 1 ADM move i.e. around 300 points is what call buyer is looking for and there was only 1 day to expire for 24th August 2023 contract. So, gap up was the only way for the market maker and that’s where you go for a kill. 44,400 CE was bought INR 131 on 23/08 and sold on 24/08 at INR 350. This is the level of accuracy of volatility adjusted option valuation. There are two choices we have as options traders. Either we use the tools intelligently and spot the opportunities to make it to the top 5%. Or be a part of the bottom 95% looking to spot the trend from the charts thus fail to identify the big opportunities.