Option Pain

The ‘Option Pain’ theory does just this – identify the price at which the market is likely to expire considering least amount of pain is caused to option writers.

Option Pain – “In the options market, wealth transfer between option buyers and sellers is a zero sum game. On option expiration days, the underlying stock price often moves toward a point that brings maximum loss to option buyers. This specific price, calculated based on all outstanding options in the markets, is called Option Pain. Option Pain is a proxy for the stock price manipulation target by the option selling group”.

I preferred doing this when there were 15 days to expiry.

• I identified the expiry value as per the regular option pain method.
• I would add a 5% ‘safety buffer’. So at 15 days to expiry, the theory suggest 7800 as expiry, then I’d add a 5% safety buffer.
• I would set up strategies keeping this expiry range in mind, my most favorite being to write call options beyond 8200.
• I would avoid writing Put option for this simple belief – panic spreads faster than greed. This means markets can fall faster than it can go up.
• I would hold the options sold up to expiry, and would usually avoid averaging during this period.

PCR Ratio

The Put Call Ratio is a fairly simple ratio to calculate. The ratio helps us identify extreme bullishness or bearishness in the market. PCR is usually considered a contrarian indicator. Meaning, if the PCR indicates extreme bearishness, then we expect the market to reverse, hence the trader turns bullish. Likewise if PCR indicates extreme bullishness, then traders expect markets to reverse and decline.

To calculate PCR, all one needs to do is divide the total open interest of Puts by the total open interest of the Calls. The resulting value usually varies in and around one.

PCR Tips

• If the PCR value is above 1, say 1.3 – then it suggests that there are more Puts being bought compared to Calls. This suggests that the markets have turned extremely bearish, and therefore sort of oversold. One can look for reversals and expect the markets to go up.
• Low PCR values such as 0.5 and below indicates that there are more calls being bought compared to puts. This suggests that the markets have turned extremely bullish, and therefore sort of overbought. Once can look for reversals and expect the markets to go down.
• All values between 0.5 and 1 can be attributed to regular trading activity and can be ignored.
• PCR beyond 1.3 or below 0.5 is what I really consider worth noting, none of the other values signify anything much.

• DONOT SHORT PUT OPTIONS (panic spreads faster than greed)
• BETTER TO WRITE CALL OPTIONS
• Select appropriate strike only the week before expiry and not before that.
• short options only on the last Friday before the expiry week (around the closing time).
• Strike around 1 SD if writing 3-4 days before expiry, else 2 SD away.
• Get out of the trade when the option transitions from OTM to ATM.
• Use this strategy on liquid stocks and indices (Nifty, Bank Nifty, SBI, Infosys, Reliance, Tata Steel, Tata Motors, and TCS

Full Text

Put Options - I don’t like to short PUT options for the simple reason that panic spreads faster than greed. If there is panic in the market, the fall in market can be much quicker than you can imagine. Hence even before you can realize the OTM option that you have written can soon become ATM or ITM. Therefore it is better to avoid than regret.

Call Options – You inverse the above point and you will understand why writing call options are better than writing put options. For example in the Nifty example above, for the 8900 CE to become ATM or ITM Nifty has to move 438 points over 16 days. For this to happen, there has to be excess greed in the market…and like I said earlier a 438 up move takes a bit longer than 438 down move. Therefore my preference to short only call options.

Strike identification – I do the whole exercise of identifying the strike (SD, mean calculation, converting the same w.r.t to number days to expiry, selecting appropriate strike only the week before expiry and not before that. The timing here is deliberate

Timing – I prefer to short options only on the last Friday before the expiry week. For example given the August 2015 series expiry is on 27th, I’d short the call option only on 21st August around the closing. Why do I do this? This is to mainly ensure that theta works in my favor. Remember the ‘time decay’ graph we discussed in the theta chapter? The graph makes it amply evident that theta kicks in full force as we approach expiry.

Premium Collected – Because I write call options very close to expiry, the premiums are invariably low. The premium that I collect is around Rs.5 or 6 on Nifty Index, translating to about 1.0% return. But then I find the trade quite comforting for two reasons – (1) For the trade to work against me Nifty has to move 1 SD over 4 days, something that does not happen frequently (2) Theta works in my favor, the premiums erode much faster during the last week of expiry favoring the option seller

Why bother ? – Most of you may have this thought that the premiums are so low, why should I even bother? Honestly I too had this thought initially; however over time I have realized that trades with the following characteristics makes sense to me – - Visibility on risk and reward – both should be quantifiable - If a trade is profitable today then I should be able to replicate the same again tomorrow - Consistency in finding the opportunities - Assessment of worst case scenarios - This strategy ticks well on all counts above, hence my preference.

SD consideration – When I’m writing options 3-4 days before expiry I prefer to write 1 SD away, however for whatever reason when I’m writing the option much earlier then I prefer to go 2 SD away. Remember higher the SD consideration, higher is the confidence level but lower is the premium that you can collect. Also, as a thumb rule I never write options when there is more than 15 days for expiry.

Events – I avoid writing options whenever there are important market events such as monetary policy, policy decision, corporate announcement etc. This is because the markets tend to react sharply to events and therefore a good chance of getting caught on the wrong side. Hence it is better safe than sorry.

Black Swan – I’m completely aware that despite all the precaution, markets can move against me and I could get caught on the wrong side. The price you pay for getting caught on the wrong side, especially for this trade is huge. Imagine you collect 5 or 6 points as premium but if you are caught on the wrong side you end up paying 15 or 20 points or more. So all the small profits you made over 9 to 10 months is given away in 1 month. In fact the legendary Satyajit Das in his highly insightful book “Traders, Guns, and Money” talks about option writing as “eating like a hen but shitting like an elephant’. The only way to make sure you minimize the impact of a black swan event is to be completely aware that it can occur anytime after you write the option. So here is my advice to you in case you decide to adopt this strategy – track the markets and gauge the market sentiment all along. The moment you sense things are going wrong be quick to exit the trade.

Success Ratio – Option writing keeps you on the edge of the seat. There are times when you feel that markets are going against you (fear of black swan creeps in) but only to cool off eventually. When you write options such roller coaster feelings are bound to emerge. The worst part is that during this roller coaster ride you may be forced to believe that the market is going against you (false signal) and hence you get out of a potentially profitable trade. In fact there is a very thin line between a false signal and an actual black swan event. The way to overcome this is by developing conviction in your trades. Unfortunately I cannot teach you conviction; you will have to develop that on your own J. However your conviction improves as and when you do more of these trades (and all trades should be backed by sound reasoning and not blind guesses). Also, I personally get out of the trade when the option transitions from OTM to ATM.

Expenses – The key to these trades is to keep your expense to bear minimum so that you can retain maximum profits for yourself. The expenses include brokerage and applicable charges. If you short 1 lot of Nifty options and collect Rs.7 as premium then you will have to let go few points as expense. If you are trading with Zerodha, your expense will be around 1.95 for 1 lot. The higher the number of lots the lesser is your expense.

Instruments – I prefer running this strategy on liquid stocks and indices. Besides Nifty and Bank Nifty I run this strategy on SBI, Infosys, Reliance, Tata Steel, Tata Motors, and TCS. I rarely venture outside this list.

Volatility cone provides "Realized Implied Volatility" data for a selected stock or index.

• USE THIS STRATEGY ONLY ON LIQUID OPTIONS
• Compare IV on the option contracts(from option chain) with the IV (for nearest days to expiry record) in the table. Normally compare with 2SD data in table.
• If the IV of a strike is more than historical IV(+2SD), designing a trade so as to short this option with an expectation that the volatility will cool off.
• If the IV of a strike is less than historical IV(-2SD), designing a trade so as to buy this option at low premium(cheap)
• Hint:Those options which are close to + 2SD line are trading costly and options near -2 SD line are considered to be trading cheap. Trader can design trades to take advantage of ‘mispriced’ IV. In general, try to short options which are costlier and go long on options which are trading cheap.

Full Text

For option traders, it becomes extremely crucial to assess the level of volatility in order to time the trade accordingly. If you initiate the trade when the implied volatility of options is high, then you will have to incur high upfront costs and lower profitability potential. However if you initiate the position when the option implied volatility is low, your trading position will incur lower costs and higher potential profit.

Volatility Cone data helps the trader to evaluate the costliness of an option i.e. identify options which are trading costly/cheap. The way to use table would be to first identify the ‘Number of days to Expiry’ and then look at all the data points that are plotted right above it. For example if the number of days to expiry is 30, then observe the data points (representing realized volatility) right above it to figure out the ‘Minimum, -2SD, -1SD, Average implied volatility etc’. The table data shows selected Stock/Index's near month and next month implied volatility on the volatility cone. Compare IV on the option contracts(from option chain) with the IV (for nearest days to expiry record) in the table. Normally compare with 2SD data in table.

- If the IV of a strike is more than historical IV(+2SD), it means that today this srike (CE/PE) is experiencing an implied volatility, which is higher (by +2SD) than the volatility experienced in this stock whenever there are “X days to expiry” over the last 15 months. Therefore this option has a high IV, hence the premiums would be high and one can consider designing a trade to short the ‘volatility’ with an expectation that the volatility will cool off.

- If the IV of a strike is less than historical IV(-2SD), It suggests that, this particular option(strike) has very low IV, hence low premium and therefore it could be trading cheap. One can consider designing a trade so as to buy this option.

Hint:Those options which are close to + 2SD line are trading costly and options near -2 SD line are considered to be trading cheap. Trader can design trades to take advantage of ‘mispriced’ IV. In general, try to short options which are costlier and go long on options which are trading cheap.