Of all the different methods that are used to evaluate the fair value of an option premium, neutralizing the volatility premium provides the strongest edge. The obvious question is why? First, volatility does not follow any historical reference point. The second and the most important reason is, when you neutralize the volatility, it is a real-time activity involving live data inputs. Hence it provides pinpoint accuracy in picking up strikes at the time of execution. In today’s article, we shall discuss what terminal volatility is & how it can be used. What is Terminal Volatility?
In essence, terminal volatility is a tool that measures the speed of the market. We know that prices are driven by emotions in the trader's mind. These emotions are often classified as demand & supply in conventional economics. However terminal volatility looks at these shifts as extreme confidence or extreme uncertainty. It works to identify the point where an option buyer has no point of return. The Trigger
We all know that there was news of Federal Reserve raising interest rates was swirling in the market. The RBI will also, now, act accordingly. This news brought confusion in the market, and it added fuel to the call option seller. This caused Call premiums to overheat. Today at 12:46 PM in the afternoon, when bank nifty registered a high of 40,201 the terminal volatility gauge spotted an exponential expansion in the 39,600, 40,000, 40,200 call options in the 23rd of March 2023 contract. I had shared our insights yesterday on LinkedIn and twitter.
The 40,000-call strike had already overheated and registered a high of 231 when bank nifty made high of 40,201 which is 115 above yesterday’s high. At the same time CEs didn’t make a new high from yesterday which was 288 and mispricing opportunity presented itself. So, call sellers who created their positions yesterday knew their business The terminal volatility gauge indicated that the sellers had reached extreme confidence.
The Execution
40,000 calls were sold on the 26th of March contract @209. But we had to neutralize the risk that could be triggered by a sudden rise in volatility. So, we bought 40,500 Call of the same expiry contract @11. It was a credit spread as we had received INR 198 to create the spread. This risk factor depends on the extent of overpricing in the 40,000-strike call. When the market closed today, the 40,000 calls were rendered zero and the spread settled at credit of 14. The spread value was at a whopping 184. The most important point here is, we did not know whether bank nifty would be relatively volatile or relatively quiet today as it was the last day of the weekly contract. We simply neutralized the volatility and was prepared to take a maximum risk which was defined. The RR as you know was a nerve-wracking 1:4, and the best part, you received premiums to create this spread. Interesting, isn’t it?