When an option buyer enters the market, he simply wants to identify the trend. In most cases, there are two reasons for this thought process. First, the option buyer wants to determine whether he should buy a call or a put option. Second, he wants to generate 5X or even 10X returns by deploying a very small capital. Take, for example, Nifty is trading at 18,100, and he has observed that the market has been moving in 500 points for the last 20 days. Thus, he wants to grab the opportunity and make a killing. He wants to know whether to buy the 18,000 put option or the 18,200 call option. With so many strikes available on the option chain, he is faced with one question, which strike should I buy?
Find The Edge
We must know where to look if we want to find the edge. In today’s article, we shall solve this challenge for the option buyer. First and foremost, only buy options which are underpriced, never ever buy an overpriced option, no matter what the trend. The obvious question is why? This is because option sellers sell overpriced options all the time. This is the same phenomenon used by hedge fund managers when they create a spread using multi-leg options. They buy the underpriced option premium and sell the overpriced strike. Now imagine what retail traders do, they look for premiums according to their trading capital. They are focused on generating 5X return on the investment. Therefore, their long positions in an overvalued option strike stand no chance because it is the same strike the hedge funds have sold in huge quantity. So, rule number 1 is to calculate the fair value of the option strike, before you buy it. If you can do this, you will be surprised by the results, because that is where the hedge funds are sitting, and they will protect their positions.
Step 1- Calculate The Fair Value
We know that an option can either be at fair value, overvalue or undervalue. As a rule of thumb, comparing the shift in the volatility of the underlying instrument is a must, when comparing this value. This means, when you buy an option, you must incorporate the drift in the volatility of the underlying. While buying an option you are exposed to a certain percentage of the theta component. You don’t have a choice because all options have a time value component. If the drift in volatility is positive, then the theta will expand and cause the option to be overvalued in certain strikes, however, if the drift is negative, then the valuation of those certain strikes might drop below the fair value. At first glance, an option strike trading at Rs.30 might seem at a fair value compared to another option with a premium of Rs.130. Never make this mistake of comparing 30 with 130. When calculating the fair value, always compare the impact of the drift in volatility in both cases.
Live Example
Our calculations provided us a setup on Thursday which involved buying 18050 CE and 18200 PE of 25th January 2023 Expiry at a price of INR 100 per lot with strict SL of 60. So, whenever either of the strike came at 100, we have to buy it.
We first bought 18050 CE on Friday at 97 with a SL of 60 and 18050 CE made a low 87 that day. Today, on 24th January 2023, call made a high of 179 and we booked at 178(Kindly refer to the screenshot). Now, similarly, 18200 PE went below 100 yesterday i.e., 23rd January 2023, made a low of 76 and today hit the SL of 60 by making a low of 44. We took the trade there too and booked loss.
Since these trades involved overnight risk, we hedged the buy leg by selling OTM strikes. Call was hedged by 18,200 CE and Put was hedged by 18050 PE.( Kindly refer to the screenshot).
Call Spread was initiated at debit of INR 35 and squared off at debit of INR 117, making a profit of whopping INR 82 per lot i.e., (82*50=4100)
Put spread was initiated at debit of INR 64 and squared off at debit of INR 44, booking a loss of INR 20 per lot i.e., (20*50=1000).
We made up that loss by taking a contra trade. Let it be a surprise.
The Catch
Option buyers generally fail to make money either because they have not picked up the right strike, or they did not book the position at the right time. If you have not picked the right strike, then follow step 1 and correct that mistake. If you are successful in identifying the right strike but losing out because you are not booking profits, then there is a separate solution in our courses.
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