While trading Bank Nifty options traders generally ask three questions, “What is the trend”?, “What strike should I buy”? and “Where should I execute the trade?”. Option traders know that Bank Nifty undergoes huge swings and big money can be made. The last line states something very important. It says, you can earn big, as Bank Nifty undergoes huge swings. In other words, if you can calculate the volatility adjustments, you can hit the jackpot.
This is exactly how hedge fund models are designed. There’s no doubt that Bank Nifty is a money-making machine. In today’s research report we shall bust the myth around trend and deal with Bank Nifty options with the help of volatility. We shall leave you with 4 steps that can help correlate between options strikes and the underlying volatility. Step 1
Take a neutral approach and study Bank Nifty’s behavior. If you look closely, you will notice, Bank Nifty had undergone incredible swings in the past few sessions. The index had dropped sharply by 3,660 points from the recent high of 43,079 and then bounced back more than 2,595 points from the recent low of 39,420. Given such volatility, does it make sense to look for the trend? The answer is ‘NO’. Trending markets obey uniformity of direction, the recent moves were very choppy. Therefore, rather than asking what the trend is, options traders should focus on the volatility drift in the instrument. Step 2
Are you an option buyer or seller? Take for example you want to buy and hold an option for the next 4- 5 trading days or you want to sell and hold for a few days. First, you must derive the volatility drift based on (St > K) & (K > St). This decision is very critical. To execute trades based on volatility, you would need to combine the two most important aspects. First, the volatility adjusted range of the instrument and second, selection of strikes in that range. If you are an option buyer, you pick up undervalued strikes. If you are a seller you deal with the overvalued ones. Now notice that we are not focusing on the trend at all. Here we know the maximum range where (St > K) nullifies the volatility adjusted risk. So, you must choose strikes Ck and Pk accordingly. Ck denotes the Call strike and Pk denotes the Put strike at a discreet time “t”, where St is the price of Bank Nifty. Step 3
What is the current volatility? To answer this question, you would require a model that can capture the volatility drift during live markets. We use Terminal Volatility to determine the same. Hedge funds generally have their own. Now, this is not a simple formula that you can punch during live markets because you are dealing with a volatile instrument, and we have your limitations as humans. This is where most impurities are filtered. The buyer picks the undervalued strikes, while the seller grabs the overvalued ones. Step 4
Take for example today, Bank Nifty spot opened at 41,019 in the morning. Based on Volatility Adjusted Market Movement, 42,200 Call and 40,300 Put option was identified. Notice at 12:22 PM St is in 40,927. In today’s situation, if you were an option buyer, you would buy the 42,200 Call option around Rs.48 as it was undervalued. While the 40,300 Put could have been sold by the option seller around 220 it was over-valued. The most important thing to notice here was, Volatility Adjusted Market Movement were indicating to buy a Call or Sell a Put. Based on our risk evaluation model we sold the 42,200 Put @ 228. The short position was covered at Rs 102 and closed @ 94 at the end of the day as the equation (St > K) was a perfect match. For those who are wondering what happened to the Call? It closed at Rs.130 at the end of the day proving yet again that the 42,200 call option was indeed undervalued at 12.22 PM.