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.
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 come into play. If you had been tracking the market in the last few days, you will know very well, that Bank Nifty deep ITM Puts failed to cross 8th Sept’s high although 9th Sept there was a new low in Bank Nifty. 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
Take for example yesterday’s and todays situation, Bank Nifty did display overvaluation on puts side. Calls were not shedding away its premium and puts were continuously adding premium (A clear sign of retailers wrapping up their sold puts). In such a situation, thinking like a smart money will always reward you. Here we are looking to analyze the volatility adjusted market movement. Therefore we used terminal volatility to gauge how far Bank Nifty options could jump or drop. Next, we checked the theta adjusted valuations to spot a call and put strike in that range that was undervalued and was within our risk appetite. The 50,600 Call option was a perfect match, however, the subsequent Put strike in the volatility range did not meet the criteria. So we bought the 50,600 Call option at INR 267 around 10:14 am in the morning on 9th September. Today, we squared off the same call at INR 706. A whopping 165% gain in a day’s time.
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