If you have been a trader for 6 months, you must have heard about contra trades. In today’s article we shall talk about “Contrarian Option Trading” (COT). COT is a powerful Alternative Investment Technique. This method is sleek and is very powerful as it uses the volatility adjusted time decay of options to determine fair value of a strike. Contrarian option trading is known for its pinpoint accuracy and provides a strong edge for option buyers. When you are buying options with a small premium, your investment is extremely small, compared to the option seller’s large fixed margin. Imagine you buy 4 lots of option in Nifty @ INR 25, with a volatility adjusted risk of INR 10. Here your total investment is just INR 5,000. Then you sell the position @75 intraday. Your net profit is INR 10,000, on a risk of INR 1,000. The important question is, what is “COT” and what are the advantages of this tool? Simply put, COT is a volatility adjusted price band in Nifty where specific Call options become dangerously undervalued during a falling market. While specific Put options are dangerously undervalued during a rising market. The advantages are. 1. COT requires extremely small investment 2. RR ratio is very attractive 3. Targets are achieved in the same day or next day.
COT Is A Function Of Weekly Option Contract
We all know that every Nifty futures contract has 4 different weekly option contracts. This is exactly what COT takes advantage of. It identifies the undervalued option strikes at discreet time “t’ based on the volatility adjusted fall or rise in Nifty during the specific week. So what does this mean? To simplify this, let us imagine you are at the park observing 4 kids playing on a swing. Now imagine each kid sat on the swing and someone pushed the swing with the same force every time. You started noting down the number of oscillations before the swing came to rest. What you will notice is the number of oscillations will be different for each kid, although the push force and the swing is the same. The important question is why does this happen? The answer is simple, the total number of oscillations of the swing, depends on the weight of the kid and the contra force of wind at the time. Now let’s apply this mathematics to the Nifty options. In Nifty the futures contract is the same and the underlying volatility is the same. But the 4 weekly contracts are like those 4 different kids. Each of these weekly contracts will have its own COT zone depending on its volatility smile. Identifying The “COT” Zone
The first step is to identify which option strikes are undervalued when Nifty enters the COT zone. We use Terminal Volatility to extract this data. You can also use the covariance of the Vega and the theta based on the volatility drift of the underlying instrument at discreet time”t”. Once the strike is identified, the rest is simply plug_and_play.
The Live Example
Our total premium calculation indicates us as to at what levels can reversals happen and their respective stop loss and till where the market can further extend if SL is hit. These levels are already given to us by market every week on every Friday so that once can capitalise the reversals in that weekly expiry.
Our Sell entry level was 18,461 with a strict Sl of 18,482. Nifty gave us an entry on 15th May itself (Monday) by making a high of 18,473. Target was 18,292 which is supposed to be achieved by Tuesday or Wednesday. Since all our calculations were ready and we identified an undervalued put which was 18,400 PE. The same strike was bought at INR 61 with an SL of 21 points and hedged with 18,200 PE. The spread was initiated at a debit of INR 43 the same put was squared off at INR 233 and spread was closed at INR 165. A whopping 400% appreciation. This is why Hedge Funds use these Alternative Investment Techniques while retail clients are mostly foxed by the technical charts.