If you are a Bank Nifty options trader, you are certainly aware of what volatility is. However, the moment someone asks you to apply the same concept and trade Bank Nifty options, you are lost. In today’s article, we shall look deeper into this seemingly complex topic and come up with an easy solution. We shall also provide a live trade to make life easy.
We all know that Bank Nifty undergoes huge volatility shifts on a daily basis. So what does this actually mean? Theoretically, volatility can be defined as the standard deviation of the return provided by stock in one year. This is where things get interesting; you must understand that volatility in options is not the same as volatility in the equity market. The important question is why? The answer is simple; stocks do not undergo theta decay with the passage of time when markets witness low volatility. This is exactly why option trading requires a keen sense of understanding of how the Greeks are correlated. In this case, the relationship between volatility adjustments and theta decay. This concept is immensely powerful and works like magic for instruments like Bank Nifty options. For ease of understanding, we shall break it down to 2 steps. First, we shall look into the theta decay progression and then correlate it with volatility. Step 1
Observe Bank Nifty’s behaviour from a neutral standpoint on the 26th April 2023. If you look closely, you will notice, Bank Nifty had undergone incredible swings. The index has oscillated between 42,280 to 43,036 in last 4 trading sessions. Given such volatility, it is quite obvious that put option buyers would have bought OTM strikes in Bank Nifty because retailers always think market may fall at any point of time. If this is true, then there would be specific put strikes that are heavily overbought. At this time it is important to calculate the volatility adjusted theta drift and identify the put strikes that are over-valued. Step 2
Think like an option seller. Take for example you want to sell a put option when Bank Nifty had fallen more than 500 points and hold it overnight. You certainly would need to ensure that the option you are selling is heavily overbought. Why is identifying an overbought option so important? This step will ensure that the market maker will dare not build long positions in that strike at all. Thus, stay focused on the fair value of the option and find out the volatility adjusted market movement.
When Bank Nifty plunged 402 points on the 26th April 2023 from 25th April’s high, we used volatility adjustments together with the theta progression and found out that the 42,500 Put was heavily overbought. Keep in mind that we are simply correlating the options theta progression with respect to the shift in the Vega component. Thus the 42,500 Put was sold at 171 on the 26th April 2023. If you look closely, you will notice, that Bank Nifty opened flat and rallied 190 points on 27th April. The question is why? Well, you should have guessed it by now, the market makers simply ate up the excess valuation in the 42,500 Put option. The 42,500 Put options melted away like ice-cream under the hot sun. We closed our position at INR 14, netting a total profit of INR 157 per lot. The same setup was found in today's market (28th April 2023) and following trade was taken with very well rewarded us.