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 First, volatility does not follow any historical reference point.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
Rather than explanation, I will show it through numbers. Look at the table below. From Day 1 of Bank Nifty 16th July expiry to Day 4, ATM decreased everyday with corresponding decrease in OTM, except day 4. Day 4, ATM decreased and OTM increased. WHY? On 11th July itself, premiums indicated a range, so what was s special about day 4 – Monday (15th July). Bank Nifty futures had made a new low with inflating put premiums which was indicated right in the OTM open price. Smart money needed more premiums to sell, so a shakeout maybe? Amplify used this reference point of 15th July and executed a Intra-day trade on 16th July (Tuesday). Remember, odds are stacked in favor of range, so extreme movement either side will revert to mean.
The Execution
We sold heavily 52,400 PE @124 and put strict SL. Also hedged the same with OTM puts that costed us pennies. We simply neutralized the time value and were prepared to take a small loss if SL triggers. The RR as you know was a nerve-wracking amazing, and the best part, you received premiums to create this spread. The same put was covered @ 20. Interesting isn’t it?
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