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What is a Ratio Trade, How Can We Build Them?

Nifty Futures has been trading in an extremely narrow corridor of 400 points since the 26th Oct 2023. In today’s session, the index is stuck in a range of 110 points between 19,175 and 19,065. As traders, we need to ask questions like what causes these narrow range-bound movements and is there a way to take advantage of these scenarios. To understand this phenomenon, we must look into Volatility and the demand-supply curve.

Volatility and the Demand-Supply Curve Look at it this way, all market movements are reflections of the demand-supply curve. When the demand outruns the supply, price is pushed up. Similarly, when the supply outruns the demand, price is forced down. At this point, volatility adds a spin to this equation. The next question is, “what is volatility”?

What Is Volatility? Volatility sounds like a complex term, but in reality, it is the measure of uncertainty or risk. Volatility also plays a very crucial role in determining the price of Call and Put options. Mathematically, Volatility is the standard deviation of returns generated by an instrument. Traders need to keep in mind that, we are considering the continuous compounding returns of the instrument in one year. Simply put, option volatility is the standard deviation of the natural log of the instrument over the complete span of its life. Institutional traders use the shift in volatility to create ratio spreads and generate returns when the market slips into a narrow range.

What Are Option Ratios? Ratios are intelligently crafted option spreads. They are often used as volatility spreads to generate returns from the market. These spreads are meticulously designed depending on the time to expiry and the drift in the market volatility. However, the Gamma and Vega in volatility spreads are comparatively weaker than the conventional straddle or strangle. During low volatility, ratios are built so that the payoffs at expiration are maximized. It is very similar to the situation we are experiencing now in Nifty.

How to build ratios during low volatility Look for the shrinkage in the Options Gamma and Vega. This is what generates the profits while there is a constant decay in the theta. Although there is a buyer for every seller at all times, the Options Gamma and Vega covariance factors for a ratio spread during low volatility will normally be less than those for straddles and strangles. The idea is to take advantage of the mispricing in the options market. Thus we will buy options that are underpriced and sell those, that are overpriced. The trick to capturing the mispricing lies in the implied standard deviations or implied volatility. Simply put, we will buy options with implied volatilities below normal and sell those with implied volatilities above normal.

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