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Trading Options On Technical - Anjana G
Trading Options On Technical - Anjana G
Many traders are always searching for a free ride, and they are
always looking for free tips or a guru who can teach them to make
profits every time. In derivatives trading, good performance is usually
a result of lady luck; markets are random, so no guru or system will
be helpful in the long run. The only way to make it in trading is to
earn it. Use the wisdom of gurus/experts but make your own
decisions and be willing to take responsibility for your own choices.
No one is right every time, but you should make money more often
than you lose, and profitable trades should make more than losing
trades lose.
Trading in derivatives is a probability game. The probability and
amount of success should be higher than the probability and amount
of loss. In comparison, many retail investors are doing just the
opposite. Novice Indian retail traders are losing money
systematically; they take naked positions in derivatives and trade for
small profits, whereas on the loss side, they hold the position and
hold it with them for a long until the price comes back. In this case,
whenever there will be a significant movement in an adverse
direction, they will lose a considerable amount and leave the capital
market with substantial losses. The better way to do all these things
is to use option spreads and combinations in a disciplined manner.
The payoff for the seller of Put Option – A trader sold Nifty Put
option with strike 10000 at a premium of Rs 73/-. So he received a
premium of Rs 5475/- (Rs. 73 multiplied by a Nifty lot size of 75).
Seller of Option is required to pay margin. The margin on option sell
is equal to the margin on Future buy/sell. His profit is limited to the
premium of Rs 5475/- received. However, the risk profile is unlimited.
The loss will increase with the price decrease. The breakeven point
will be strike - premium. So if Nifty closes above 9927, then the seller
will make money.
Comparison of buying future Vs.
buying an Option
Please refer to Table 3: Option chain Nifty (This option chain may
also be referred from the NSE India website; data updates live with a
few minutes delay). If you check the Open Interest (OI) column,
10000 call options have the highest open interest of 4083300, and
9800 put have the highest open interest of 5366775. Technically
10000 is having a strong resistance, and 9800 is having strong
support till expiry. (The example referred to is of monthly options only
and add open interest of weekly options strikes for computation of
open interest-based resistance or support level for the month/week).
Suppose a trader is bearish on Nifty because Nifty is trading at its
strong resistance level of 10,000. Options give many choices to
trade; let's discuss some alternatives if the trader wants to go short –
- First, Traders can sell the future of Nifty. As mentioned in the
above examples selling future at 10000 will have a risk profile
of unlimited loss and profit potential of unlimited profit.
- Second, Traders can buy any put option of Nifty. For example,
if he buys a put option with a strike price of 10000 at Rs 83,
then the profit potential is unlimited like the future, but the risk is
limited to the premium of Rs 83 paid. One more noticeable
difference is, selling a Nifty future requires margin, whereas
traders can take a position in a put option with Rs 6225 only
(Rs 83 X Lot 75 = 5475).
So options are providing more leverage than futures for taking
exposure in the same quantity. The maximum cost, in this case,
is Rs 83. If the underlying expires at 10,000 or above, the
trader will lose 100% of the money (Rs 83/-). So options can
fund the cost also.
- Third, a trader can sell the put option with a strike price of
9800 at Rs 34/- along with buying a put with a strike price of
10000 at Rs 83. Now maximum risk in this trade has come
down to Rs 49 (83 -34), and maximum profit is limited to Rs
151 (Total Rs 11325 = Premium 151 X Lot 75). So you can say
that if a trader is wrong, they will lose X amount; however, if a
trader is right, they will earn 3X amount. So risk-reward ratio is
1:3. In this case, the margin blocked will be significantly
lesser than the future sold after new rules applicable from
1st June 2020. A trader can also sell two lots of 9800 put at 34
and buy one lot of 10000 put at Rs 83; this is called ratios. We
will discuss ratios and price behavior of options before expiry in
detail later on. Now we know ATM options have only time
value, and there is no intrinsic value. So if Nifty remains at
10000 till the expiry, the buyer of the option will lose the
premium. So a trader can sell any Call option if the view is
bearish.
- Fourth, the trader can sell the Call option if they are bearish. A
call option with a strike price of 10000 is trading at Rs 96/-.
Even if Nifty remains at 10000 or below, a trader will make
money; however, in this case, profit is limited to the premium of
Rs 96 (Total Rs 7200 = 96 X 75), and the risk profile is
unlimited. A trader can buy a call option with a strike price
10100 at Rs 49 along with selling a Call option with a strike
price of 10000 at Rs 96, In this case, the maximum profit
potential is Rs 47 (96-49), and the maximum possible loss is Rs
53/-. A trader can make a maximum profit of Rs 3525/- per lot
(Premium 47 X lot 75), and maximum loss is limited to Rs
3975/-(Premium 53 X lot 75). Selling the naked option is not a
good choice. It's better to buy a low-price option to limit the
maximum loss along with the selling of an option. The trader
will get margin benefit too.
Table 3: Option Chain Nifty (Nifty Trading at 10000)
One of the best things with options is that there are many ways to
use them. Options make it possible to trade in the market with limited
risk and trade with limited money.
1. Stock price
2. Strike price
3. Time to expiration
4. Volatility
5. Interest rate
6. Dividends
All inputs are dynamic except Strike Price. If the trader knows all of
these inputs, he can use the Option Calculators to arrive at the
theoretical price of an option. If one does not know any input, they
can use the option price (premium) to calculate it. We all know at
what price/premium any option is trading in the market. This
price/premium is used to calculate the volatility that is called implied
volatility. When the price of an option changes, it means anyone or
more than one out of five input variables has changed.
Understanding these variables and Greeks is essential to
understand the price behavior of an option before expiry. Let's know
the Greeks.
Delta
The options price of various strikes moves differently with the
movement in prices of the underlying asset. Time to expiry is also
had an impact on the option price. Is there any mathematical way to
estimate how much the price of an Option contract will move with a
change in the underlying price?
Note that a put option with the same strike price will decline with an
increase in the underlying price and therefore have a negative Delta.
So any option contract that has a 0.50 delta means a premium of the
option contract will increase by 0.50 paisa with Rs1 increase in the
underlying asset, and if the price of the underlying asset came down
by Rs 1, then option premium will also come down by 0.50 paisa.
The Delta for a Call option always ranges from 0 to 1, and the Put
option Deltas always range from -1 to 0. So call prices will increase
with the underlying price; however, put prices will decrease with an
increase in the underlying price.
It's essential to understand how your option will move with a change
in the stock price. Without understanding Delta, it's hard to know the
price behavior of options with respect to changes in the underlying
asset price. Delta of options contract changes with the change in
input of option pricing model. Understanding the behavior of Delta
with change in input is essential for traders to use this Greek in
options trading. The price of options of Nifty in September 2015 of
various strikes and their Delta is given in below Table.
Delta of 7500 call which is in the money by 500 points is 0.99, so the
Rs 1 change in Nifty will result in 0.99 paisa in a change in the price
of 7500 call. 7800 Call is in the money by 200 points, and Delta is
0.81, so 1 point change in Nifty will result in a change of Rs 0.81 in
the premium of 7800 call.
The value of Delta is coming down with the increase in the strike
price of the call option. If Nifty changes from 8000 to 8010, then
8400 Call will change by 60 paisa only from Rs 40 to 40.60 approx
and 8300 Call will change by Rs 1.2 only from Rs 63 to Rs 64.20.
In Put options, Delta for in the money option is high and out of
money is low. It is to be observed in Table 4 [Strike wise Delta] that
the Delta of ATM strikes is near 0.50. Delta of In-the-money strikes is
more than 0.50, and deep in the money option is closer to 1. Delta of
out of money options is less than 0.50, and deep out of money
options is closer or 0. It is again to be observed in Table 4 that the
value of both Delta of the same strike is 1. If you add the value of call
delta and put Delta of the same strike, the result is one because of
call put parity. Put-call parity works in European options. Today Stock
options, as well as Index options, are European style. We will
discuss this put-call parity in detail when we will understand the
strategy of conversion and reversal.
Delta is also used for the probability that a call will expire in the
money. So a stock with a delta of 50% is deemed to have a 50%
chance of finishing in the money. An option with 0.25 Delta would be
thought of having a 25% chance of expiring in the money. If there is
less time for expiry, then there is less chance of expiring in the
money of the OTM strike. So when time is less, OTM strikes moves
to zero, and ITM strikes move to 1. If the time to expiry will be more,
then the Delta of all strikes will move towards 0.50.
Please refer to Table5 for the Delta of various strikes of Nifty call
options at different times to expiry if volatility is approx 11%. The
Index is trading at 8000, so 8000 is an ATM strike. With the change
of 10 points in Nifty, 8200 call will change by Rs 1.10 when there are
only ten days to expiry; however, the same strike will change by Rs
4.5 when there are 80 days to expiry.
Table 5: Delta of Call Options
Time to Expiry
Strike 1 5 10 20 40 80
Prices Day Days Days Days Days Days
7500 ITM 1 1.00 1.00 1.00 0.98 0.95
7600 ITM 1 1.00 1.00 0.99 0.95 0.91
7700 ITM 1 1.00 0.99 0.95 0.90 0.87
7800 ITM 1.00 0.98 0.94 0.88 0.83 0.80
7900 ITM 0.99 0.86 0.79 0.75 0.73 0.73
8000 ATM 0.52 0.54 0.55 0.57 0.60 0.64
8100 OTM 0.02 0.19 0.29 0.38 0.47 0.55
8200 OTM 0.00 0.03 0.11 0.22 0.34 0.45
8300 OTM 0.00 0.00 0.03 0.11 0.23 0.36
8400 OTM 0.00 0.00 0.01 0.04 0.14 0.28
8500 OTM 0.00 0.00 0.00 0.01 0.08 0.21
Strike Volatility
Prices 5% 10% 20% 30% 40% 50%
7500 ITM 1 0.99 0.90 0.81 0.76 0.72
7600 ITM 1 0.98 0.86 0.77 0.72 0.69
7700 ITM 1 0.95 0.80 0.72 0.68 0.65
7800 ITM 0.99 0.87 0.72 0.66 0.63 0.62
7900 ITM 0.91 0.75 0.64 0.61 0.59 0.58
8000 ATM 0.67 0.59 0.56 0.55 0.54 0.55
8100 OTM 0.33 0.42 0.47 0.49 0.50 0.51
8200 OTM 0.09 0.26 0.38 0.43 0.46 0.47
8300 OTM 0.01 0.14 0.30 0.37 0.41 0.44
8400 OTM 0.00 0.06 0.23 0.32 0.37 0.41
8500 OTM 0 0.03 0.17 0.27 0.33 0.37
When Nifty is trading at 10000, ATM call of Nifty is trading at Rs 98.45, Delta is
0.60, and Gamma is 0.0021. One point change in Nifty should result in 0.60
paisa change in 10000 call and 0.0021 point change in Delta. So 10 point
change in Nifty resulted in a Rs 6 (0.60 X 10) change in the price of Call. Delta
also increased by 0.020 (10 X 0.002) from 0.60 to 0.62. When there is a rise in
the price of Nifty by 40 points, then the price of Call should increase by Rs
24.80 (40 Multiplied by the Delta of 0.62). However, the price of the Call is Rs
130.77, increased by Rs 26.26. The difference of Rs 1.46 (26.26-24.80) is due
to Gamma (as Delta also changes with price change). Delta should also
increase by 0.08 (.0020 X 40) because of Gamma, whereas Delta increased
by only 0.07 points only (From 0.62 to 0.69) because Gamma is decreasing
with an increase in Nifty. Gamma, which was 0.0020 at 10010, came down to
0.0019 at 10050. So Gamma is also dynamic. ATM options have relatively
high Gamma, whereas ITM and OTM options have low Gamma.
As we can observe in Table 8, ATM strikes have the highest Gamma, and the
rate of change of Delta is decreasing as the strike is going more out of money.
Table 8: Gamma & Strike
Call Put
Options Options
Strike Prices Gamma Gamma
ITM 9,600.00 0.0001 0.0001
ITM 9,700.00 0.0004 0.0004
ITM 9,800.00 0.0009 0.0009
ITM 9,900.00 0.0015 0.0015
ATM 10,000.00 0.0019 0.0019
OTM 10,100.00 0.0019 0.0019
OTM 10,200.00 0.0015 0.0015
OTM 10,300.00 0.0010 0.0010
OTM 10,400.00 0.0005 0.0005
It can be observed in Table 9, Gamma of ATM strike is more when the time to
expire is less. As discussed earlier also, each Greek impacts another Greek,
which is why the Gamma is different at different times to expiry.
Time to Expiry
5 10 20 40 80
Strike Prices 1 Day Days Days Days Days Days
ITM 9,600.00 0.0000 0.0000 0.0000 0.0001 0.0003 0.0003
ITM 9,700.00 0.0000 0.0000 0.0001 0.0004 0.0005 0.0005
ITM 9,800.00 0.0000 0.0003 0.0007 0.0009 0.0008 0.0006
ITM 9,900.00 0.0004 0.0020 0.0019 0.0016 0.0012 0.0008
ATM 10,000.00 0.0095 0.0042 0.0029 0.0021 0.0014 0.0009
OTM 10,100.00 0.0006 0.0027 0.0025 0.0020 0.0015 0.0010
OTM 10,200.00 0.0000 0.0005 0.0012 0.0015 0.0014 0.0011
OTM 10,300.00 0.0000 0.0000 0.0003 0.0009 0.0011 0.0010
OTM 10,400.00 0.0000 0.0000 0.0000 0.0004 0.0008 0.0009
Volatility
Strike Prices 5% 10% 20% 30% 40% 50%
ITM 9,600.00 0.0000 0.0000 0.0000 0.0000 0.0003 0.000437
ITM 9,700.00 0.0000 0.0000 0.0001 0.0004 0.0006 0.000755
ITM 9,800.00 0.0000 0.0000 0.0006 0.0011 0.0012 0.001113
ITM 9,900.00 0.0000 0.0011 0.0023 0.0020 0.0017 0.001404
ATM 10,000.00 0.0152 0.0076 0.0038 0.0025 0.0019 0.001524
OTM 10,100.00 0.0000 0.0014 0.0025 0.0021 0.0017 0.001429
OTM 10,200.00 0.0000 0.0000 0.0007 0.0012 0.0012 0.001163
OTM 10,300.00 0.0000 0.0000 0.0001 0.0005 0.0007 0.000825
OTM 10,400.00 0.0000 0.0000 0.0000 0.0001 0.0003 0.000512
Delta hedging / Gamma scalping –
Now we understand Delta and Gamma and the impact of other Greeks on
both. Let us take one theoretical example to understand delta hedging and the
gamma effect.
Nifty is trading at 10000. Nifty call option 10000 is trading at Rs 113/-. There
are 25 more days to expiry & implied volatility is 8%. For example, I want to
sell 20 lots of Nifty call options with a strike price of 10000 at 113. Delta of
10000 call options is 0.6, so I need to sell 12 lots Nifty future to hedge the
price risk of Calls sold.
Position Position Profit
Contract Price (Lots) Delta Delta /Loss
Nifty Call
10000 113 -20 0.6 -12 0
Nifty
Future 10000 12 1 12 0
Net 0 0
Assume Nifty goes up by 20 points. I sold the calls, but I also bought the future
to hedge my position, so the net profit loss is Nil. If I have not bought the
future to hedge the Delta, this price rise must have resulted in the loss.
Assume that after two days, Nifty goes up to 10050. Position of sold calls is in
loss, but the position of future bought is in profit. ATM Call of 10000, which I
sold two days back, is now in the money. Delta has increased to 0.7.
Now we need to buy two more lots of Nifty future to make this position delta
neutral.
Assume after two more days Nifty came back to 10000. 4 days back when
nifty was trading at 10000, call with a strike price of 10000 was trading at 113,
but after four days, this will trade at 101 because of time value (if implied
volatility of 8% remains unchanged)
Now we need to sell two lots of Nifty future to make this position delta neutral.
Let's close all positions. In total, we have sold 20 lots of call options at 113,
and we bought two lot Nifty futures at 10000 and 2 lot Nifty futures at 10050.
Finally, we squared off all positions, call options 20 lots bought at 101 and 14
lots Nifty sold at 10000. Net position is the profit of Rs 18000 because of time
value in Nifty call options and Loss of Rs7500/- on two lots which we bought at
10050 to make the position delta neutral. Net profit in trading is Rs 10500/-.
In the same example, if Nifty goes down to 50 points, the call options position
will give Rs 46500. However, the loss will be incurred on future bought.
Because market Nifty has come down, the 10000 strike call option has
become out of money, so the Delta has come down to 0.50. To make the
position delta neutral, we need to sell two lots of future at 9950, which we
bought at 10000.
There will be no profit or loss if nifty comes back to 10000 on the 3rd day.
So we lost Rs 7500/- on future position when Nifty went 50 points down and
came back. If this happens twice, we will lose Rs 15000/- and the net position
of both contracts will result in loss. So we will make money only when the time
value earned is more than the cost incurred in the delta hedge.
One more example to make delta hedging more clear, please refer to table 11.
The Index is trading at 10000. ATM call 20 lot sold at a premium of Rs 113/-.
Delta is 0.6 so 12 (20 X 0.60) lots of Nifty Future bought to hedge Delta. We
can easily calculate the profit & loss pay off on expiry for this position.
Maximum profit will be approximately Rs 1,70,000/- (113 X 75 X 20) if Nifty
closed at 10,000. But we are hedging Delta with every 50 point change in the
Index. The next day when underlying gone up by 50 points, we bought two
more lots of Nifty future to make the position delta neutral.
Table 11:
Nifty
10000
Time Call Nifty Nifty Profit
to Nifty option Future Option Option on Loss on Net
Expiry Price price position Position Delta Future Options P& L
25
Days 10000 113 12 -20 0.6 0 0 0
24
Days 10050 143 14 -20 0.7 45000 -45000 0
23
Days 10100 177 16 -20 0.8 97500 -96000 1500
22
Days 10150 214 17 -20 0.85 157500 -151500 6000
21 10200 255 18 -20 0.9 221250 -213000 8250
Days
What if the Index came down by 200 points in 4 days. There is no profit and
no loss on the position. In the below example, we make a profit when the
Index remains range-bound at the same level, and there is a fall in options
prices because of time value. Interest cost is not considered in any given
example. In selling an option, we need to provide the full margin of the futures
contract.
Nifty
10000
Time Call Nifty Nifty Profit
to Nifty option Future Option Option Loss on on Net
Expiry Price price position Position Delta Future Options P& L
25
Days 10000 113 12 -20 0.6 0 0 0
24
Days 9950 82 10 -20 0.5 -45000 46500 1500
23
Days 9900 57 8 -20 0.4 -82500 84000 1500
22
Days 9850 37 6 -20 0.3 -112500 114000 1500
21
Days 9800 22 4 -20 0.2 -135000 136500 1500
15
Days 9800 12 3 -20 0.15 -135000 151500 16500
10
Days 9800 5 2 -20 0.1 -135000 162000 27000
Let's understand the impact of time value on the option price. Please
refer to Table 12, the theoretical value of Nifty ATM Call Options
calculated when volatility is 8%. When 30 days are remaining to
expiry Call option is trading at Rs. 127.69/- and Theta is 2.78. A
theta of 2.78 indicates that the option is losing Rs 2.78/- of time
value per day. On the 29th day, the theoretical value of the option
came down to Rs. 124.91 by 2.78 when all other factors having an
impact on option price remain the same. So Theta is good for option
sellers and bad for the buyer. The buyer will lose Theta if the
underlying remains on the same price; however, the seller will make
money. Theta is 2.27 when there are 80 days to expiry. When there
are only five days to expiry value of Theta is 4.9. Theta's value
increases as expiration are near since each day represents a greater
percentage of the remaining time. Long options will always be short
Theta, and short options will always be long Theta.
Nifty Strike
10000 ATM Call
option
Time to Underlying Theoretical price Theta
Expiry Nifty Price (Rs.) (Rs.)
80 Days 10000 250 2.27
70 Days 10000 227 2.33
60 Days 10000 204 2.39
50 Days 10000 180 2.48
40 Days 10000 154 2.6
30 Days 10000 127.69 2.78
29 Days 10000 124.91 2.8
28 Days 10000 122.11 2.83
20 Days 10000 98 3.1
10 Days 10000 64 3.83
5 Days 10000 43 4.9
2 Days 10000 25 7.04
Table 12:
You can observe from table 13, at 5% volatility, the Theta of 10000
call is 2.49; however, at 30% volatility, Theta is 8.09 if the rest of all
things remain the same. Theta will be higher when the time to expiry
is less, volatility is high, and strike is near ATM.
Theta will give you a loss if you are an option buyer, but Gamma will
help you. Options price will increase more with an increase in the
price of underlying because Delta will also increase with the increase
in the price of underlying because of Gamma, and option prices will
decrease less with a decrease in prices.
If you are an option seller, then Theta will give profit, but Gamma will
give loss. We learned the example of delta hedging in the previous
topic. In all examples, traders sold the options and hedging Delta
through the future. Because options were sold, that's why Theta was
giving profit, whereas delta hedging was giving loss. Take an
example of the Buy option and hedging delta through the future.
Gamma scalping will give you profit because the trader will sell more
future as the market will go up, and the trader will buy future as the
market will come down to make his position delta neutral. But Theta
will give loss because you are having a long position in options.
Let's compare the option price and volatility of some stocks. Please
refer to Table 14. I have taken the closing price of some stocks and
their call options as of 27th March 2020 to explain the impact of
volatility on the option price. If you check the closing price of Sun
Pharma and ICIC Bank, you will find both closed at Rs 338/-. Now
check the call strike price 340. Sun pharma call strike 340 was
trading at Rs 29/- whereas ICICI bank call strike 340 was trading at
Rs 42/-. So the Call of ICICI bank of the same strike is approximately
40% more expensive than the Call of Sun Pharma because of the
volatility. ICICI bank was more volatile than Sun pharma in the last
few days, or you can say the market is expecting more volatility in
ICICI bank prices than Sun pharma; that is why the options premium
of ICICI bank is higher than Sun Pharma. If you will compare the
option price of Indusind bank near the money strike. It is even more
expensive. It is trading at the implied volatility of 238.
Call Implied
Stock Price Strike Price volatility
Sun Pharma 338 340 29 75
ICICI Bank
Limited 338 340 42 106
Indusind
Bank Limited 411 400 115 238
Now let's understand, with an example of past data, how it will
impact your decision. The market is assumed to be too volatile in the
last few days, and traders expect a sharp recovery in the next few
days. So trader wishes to buy Sun pharma and Indusind bank both
for one week. The trader is buying one lot of Sun pharma at 340 and
Indusind bank at 410. As discussed earlier, naked positions in
derivatives can erode your all investment, as we have seen in
Crude'sCrude's future example given in this book earlier. So hedging
is the essential thing for the trader. Maximum loss and its willingness
to take must be predefined.
In the case of Sun Pharma better to buy strike 340 put trading at 30
along with buying a future. So the maximum loss is limited to Rs
30/-, the cost of put paid. Delta of this ATM put strike is approx -0.45.
So 1 Rs increase in future price will result in a profit of Rs 1 on future
position and loss of approx 0.45 paisa on option position, so every 1
Rs increase in the price of Sun Pharma will give profit of approx 55
paisa to the trader. The same is true if the price of Sun pharma falls
every 1 rs drop in price will give loss of 55 paisa. We also
understood that Gamma helps the option buyer; that's why this 55
paisa will increase with the price increase, and the loss of 55 paisa
will decrease with every 1Rs fall in the underlying price. If Sun
pharma goes up to 380, the put price will come down to approx rs
15/- (after considering the impact of the Delta, which is approx -0.45
and Gamma). So net profit will be approximately Rs 25 if prices are
achieved as expected in the next few days.
As you can observe from the above Table, when there are only two
days to expiry Vega of ATM is 2.95. It means a 1% change in
volatility will result in a change of Rs 2.95 in the premium of the ATM
strike. However, if there are 40 days to expiry, then a 1% change in
volatility will change Rs 12.69 in the premium of the same option. So
Vega is high when the time to expiry is more.
In Table 16, you can observe the impact of volatility on the value of
Vega. Vega value is increasing with the volatility. For example, when
there are 25 days to expiry, and underlying is trading at 10,000, the
value of Vega of 9800 strike option is 1.5 at 5% volatility, and the
value of Vega is 9.76 at 30% volatility.
One more thing you can observe from both of the tables is that the
value of Vega is highest on ATM strike, and it's going down as the
option is going in the money or out of money.
The payoff of buying ITM Call along with Selling OTM Call on expiry –
Payoff comparison of buying future with buying ITM Call along with Selling OTM
Call in intraday (or before expiry) –
Current Theoretical P&L Relative to Underlying Price
Changes
Future
Position Option Positions
Underlying Call Call Spread
Price P&L 9700 10300 P&L
9500 -500 -286 89 -197
9600 -400 -244 80 -164
9700 -300 -194 68 -126
9800 -200 -137 51 -86
9900 -100 -72 28 -43
10000 0 0 0 0
10100 100 78 -35 43
10200 200 161 -78 83
10300 300 248 -128 121
10400 400 339 -185 154
10500 500 433 -249 183
The benefit of Trading Option spread (Buying ITM and selling OTM) in
comparison to buying naked future position –
1. In the case of option spreads, the loss will be limited to the net premium
paid.
2. The margin required in options spread will be much lower than the margin
required on future positions.
In case of sudden fall in underlying, loss of buyer of the future position will be
huge. There is a risk of evaporation of capital also. So you need big money for the
mark to market margin. However, in case of options spread loss will be limited; you
need not to pay any MTM. If you observe, you will find that I bought the ITM option
and sold the OTM option with an equal time value, so Theta will not give any loss
on options positions.
Basics of Technical Analysis
Technical analysis today has its origins in the theories first proposed by Charles
Dow in the eighteenth century. Dow published his ideas in series of editorials he
wrote for wall street Journal. Dow Theory is all about trends. A trend is nothing
more than a somewhat constant change in price levels over time. For an Uptrend,
prices start low and move to a higher level through a series of advances and
pullbacks. For a downtrend, prices start high and move to a lower level through a
series of advances and pullbacks.
Dow Theory says that the market has three trends. First, index/Stock/Commodity
was in the upper trend when they made the higher top and higher lows. It means
lows will be higher than the previous low, and highs will be higher than the
previous high. Second, index/Stock/Commodity was in a lower trend when they
made the lower top and lower lows, as explained in the following picture. The third
is range-bound when stock is neither in up-trend nor in down-trend.
Dow Theory also says that each trend has three phases. Accumulation phase
when informed investor buy the stock, public participation phase when prices
begin to advance rapidly and distribution phase when an informed investor who
accumulated stocks on lower prices begin to distribute before anyone else starts
selling. Dow Theory also says that volume/open interest must confirm the trend.
An increase in volume/ open interest with the rise in prices will confirm the uptrend,
and an increase in volume / open interest with a drop in prices will confirm the
downtrend.
So Technical analysis is all about the trend – buying stock when the uptrend
begins, ride the trend, and sell when the trend ends at a high price. A trend
follower buys when the price trend is up and sells when the price trend is down. He
believes that if the trend is up, then it will continue to go up. If everything works as
expected, the trend follower makes money. The trend is always a matter of time
interval. In the long run, a stock may be in an up-trend, but the same may be in a
downtrend in the short run.
In the above chart, I have taken Mahindra & Mahindra (M&M) prices from April
2009 to January 2021 to explain technical terminology. As we can see in the above
chart, the stock was in an uptrend from 2009 to 2011 when prices went up by
500% from 80 to 400. I have drawn a trend line (trend line is simply a straight line
that connects a series of security prices, either tops or bottoms). Price of 400 was
working as resistance in 2011 and 2012, and the same was working as support in
2013 and 2014. (Support is the price level at which there is adequate demand for
security to stop its downward price movement, and resistance is a price level at
which there is a significant supply of stock to stop its upward price movement).
Usually, a resistance works as support when prices break resistance, as we have
seen above. From the year 2015 to 2018, this stock was range-bound. We have
seen the first false breakout in prices in the year 2017 when stock beaked all-time
high. Again we saw a successful breakout in 2018, and prices went up from 750 to
1000. In the years 2019 and 2020, the stock was in a downtrend. Again a new
uptrend started in January 2021. Now we have to see that prices will remain
range-bound or this uptrend will continue.
We can observe the same pattern in the prices chart of many stocks when there is
a reversal in downtrend and breakout in the prices above the neckline.
Round Top and Round bottoms –
Roundtop and round bottoms trend reversal pattern is illustrated in the following
charts when prices are gradually coming down or going up against the previous
trend.
Double top and Double bottom-
As shown in the following example, when the price in trend fails to create higher
highs in case of an uptrend or lower lows in case of a downtrend, they reverse
from the previous high/low.
Gaps
In an uptrend, when the current period the low price is higher than the previous
period high price (Gap up opening) indicates a continuation of an uptrend, and in
case of a downtrend, when a day high price is lower than the previous day low
price (Gap down opening) is an indication of the further downtrend. Therefore,
some technical analyst believes that price comes back once to fill the gap.
In a candle chart, there are several horizontal bars or candles that form the chart.
Each candle has three parts Upper Shadow, Body, and Lower Shadow. In a bar,
the high, low, open, and close prices are plotted. The body is colored either Red or
Green. The bar will be green if the close price is higher than the open price, and
the bar will be red if the close price is lower than the open price.
The vertical line connects high and low prices.
One can predict the price of underlying with the help of candlestick patterns
also. Some of the patterns explained in this book, for more patterns, you can
refer to Google.
1.1. Marubozu – Marubozu is a candlestick with no upper and lower shadow.
The red candle represents, selling on every price point, the bearish
marubozu. The Green/blue represents, buying on every price point, the
bullish marubozu.
1.3. Evening Star - This is a three-candlestick pattern like a morning star but
indicates a reversal of an uptrend. It is formed of a short candle sandwiched
between a long green candle and a large red candle.
It is firm when the third candlestick erases the gains of the first candle.
1.4. Hammer - This is a candle with a short body and a long lower wick, usually
located at the bottom of a downward trend, indicating that a strong buying
surge pushed the prices up despite selling pressures.
1.5. Inverted hammer - The same bullish pattern is an inverted hammer. The
difference is that the upper wick is long, while the lower wick is short.
For more patterns, you can refer to the following link -
https://en.wikipedia.org/wiki/Candlestick_pattern
Technical Analysis Indicators
We understood the trends. In this chapter, we will understand technical indicators
used to predict the trends. There is no perfect method to predict the trend, but we
will use numbers to uncover the correct direction on prices. As we have seen a
false breakout in the previous chapter, the same, we may face while trading with
numbers. A wrong prediction will result in loss. At the end of the day, we must
check the total profit earned in successful trade and loss in false trade.
We also need to consider drawdowns because if you lose 20% of capital in a false
move, you need to earn a 25% return to reach the same level. For example, you
started with Rs 100/-. You lost 20% in the false move, and now you have Rs 80/-.
You need to earn 25% of Rs 80 you have to reach the same level of Rs 100/-. So
drawdown’s in any strategy should be as much lower as possible. That’s why
we can use options spread to minimize our losses.
2. Overlap Studies
2.1. Simple Moving Average (SMA)
The moving average is one of the most popular indicators to predict the trend.
The 200-day moving average seems to have become a benchmark for
deciding that a particular stock/index is going up or down. If the stock price is
above the 200-day moving average, then the long-term trend is up. If the stock
price is below the 200-day moving average, then the long-term trend is down.
Let's understand how to compute the moving average. First, we need to
understand the mean value or average price.
Mean is the average of all numbers. Mean value is the sum of all numbers
divided by the count of all numbers.
For example a stock has given a return of 5%, 8%, 15%, 2% and 10% in last 5
years. What is the average return?
Average return = (5+8+15+2+10) / 5 = 8
So the mean value is 8; you can say the stock has given an average return of
8% in the last five years.
Let's compute the mean value in Google Sheet. In the following example, we
add the moving average of data of HDFC we fetched in Google sheet. So we
are computing 20 days moving average of close price of S.No. 1 to 20 in cell
D28, as shown in the following screenshot. Again 20 days moving average of
close price of S.No. 2 to 21 in cell D29 and so on.
D28 = average(C9: C28)
D29 = average(C10: C29)
So 20-days moving average is simply the average price over the past 20 days.
Each moving average value is computed using the most recent days used in
the calculation. Moving average is series of an average of different subsets of
the entire data set. The average is taken over for a specific period of time, for
example, 30minuts, 30 days, 50 days, etc.
A simple moving average calculates the average of closing prices. Sum of closing
prices in a particular period dividend by the number of periods in that range. Short-
term moving averages are more sensitive to price. When the price declines short-
term average declines much faster than the long-term average. As the decline
continues, the short-term average will drop further below the long-term average.
1. If the short period moving average line is above the long period moving
average, then it's a buy signal, and if the short period line is below the long
period line, it is a sell signal.
2. Short period Moving averages give the early signal of entry and exit
compared to long period moving averages.
3. Moving Average works in trending markets, but in rage-bound markets, this
strategy may give losses.
Moving average and closing price on the chart-
In the above chart, the blue line is the close price, and the orange line is the last
20 days moving average. From January 2020 to April 2020, the stock was trading
below the 20-day moving average, which means the stock was in a downtrend.
Moving average crossover is used to generate buy or sell signals. If the short
period moving average line is above the long period moving average, then it's a
buy signal (Uptrend), and if the short period line is below the long period line, it is a
sell signal (Down-trend). This works in a trending market, but in rage bound
market, this strategy may give losses. In a range-bound market means reversal
strategy will provide you with profit. One more point to note is that the long period
moving average will be smoother, but the longer moving average is later in telling
you that the trend has changed direction. You also need to keep in mind that if the
period is shorter, the number of trades will be higher, resulting in more cost,
especially when the cost of trading is high.
Which moving average use for trading is a very subjective decision, and it may
depend on the contract you are trading. You can backtest the output of different
moving averages on past data; you need to learn Python. A python is a free
software used worldwide for trading. To learn Python and backtest and develop
your trading strategies, please read my book 'Python for trading on technical'
author Anjana Gupta.
With the help of Python, we can backtest the return given by stock on various
moving averages in various periods. For example, I am computing the yearly
return given by Reliance Industries during the year 2016 to 2020 on different
combinations of moving average crossovers from 1 to 35. Thus, the trader buys
when the short moving average crosses the long moving average from the
downside and sells when the short moving average crosses the long moving
average from the upside.
When you backtest data, you will get the following output -
In the above output of excel, you will observe moving average crossover of 1 day
and five days is giving consistent return year on year (SMA denotes short moving
average and LMA denotes long moving average). So technically, you can say
Reliance is buy if trading above five days moving average. But this will result in
many trades, and the cost is associated with every trade. If you observe, moving
average crossover of 1 day and 29 days also gives a consistent return. It means if
Reliance is trading 30 days moving average, it's a buy.
One more thing you will notice is that in the year 2020, all the moving averages
have given excellent returns because prices were trending in the year 2020. We
have seen a rollercoaster ride in 2020 from Nifty 12000 to 8000 and again back to
12000. In a trending market, moving average crossover gives a good return;
however, mean reversal strategies provide a good return in the range-bound
market. As we have computed return for Reliance, in the same way, you can
compute moving average return given by any stock on past data for any
combination of moving averages.
2.2. Exponential Moving Average (EMA)
An exponential moving average is a moving average that gives greater weight
to the most recent data points. For example, a comparison of EMA and SMA is
shown in the following chart. The simple moving average is the orange line, the
Exponential moving average is the green line, and the closing prices of stocks
are the blue line.
As you can observe in the above chart when the price is touching the upper
band, the stock is in an uptrend, and when the price is touching, the lower band
stock is in a downtrend. Therefore, how to use the Bollinger band for trading will
depend on the instrument and the price behavior of that instrument.
3. Momentum Indicators
Traders may use momentum indicators to:
Identify the direction of a trend.
Find divergences between the price and the momentum indicator to identify
a potential trend reversal or continuation setup.
Take advantage of overbought and oversold conditions.
3.3. RSI
The relative strength index is intended to chart the current and historical
strength or weakness of a stock based on the closing prices of a trading period.
The limitation with RSI is that in a bull market, RSI main remains above 70, or
in a bear market, RSI main remains below 30 for a long period, so buying when
oversold or selling when overbought can give you losses.
As we discussed earlier, you can also look for price divergence in momentum
indicators. RSI can also be used to predict a divergence in the trend before the
price reverses. Divergence can usually be spotted if the price line is moving
higher, but the RSI is not. It means the relative strength of the asset weakens
when compared to the previous periods' growth. This is an indication that prices
will go down. The same is true when the closing price has been bearish for a
while, but the RSI starts posting higher values, which means the prices will pick
up.
3.4. MACD
MACD is based on the point spread difference between two exponential moving
averages of the closing price. The MACD indicator is computed by subtracting
a longer-term exponential moving average from a shorter-term exponential
moving average. Usually, we take 26 days slower moving average and 12 days
faster-moving average. This difference is further smoothed by an even faster
exponential moving average (usually nine periods) called signal line. Thus,
MACDs rely on three exponential moving averages.
MACD generally rises in case shorter-term trends gain strength and generally
declines if shorter-term trends are losing strength. Buy shares when the MACD
line crosses the signal line upwards (it is considered a bullish signal); on the
other hand, sell shares when the MACD line crosses the signal line downwards
(it is considered a bearish signal). When MACD is exceptionally high, it
indicates the top has been made, and when MACD is extremely low, it indicates
the bottom has been made.
Balance of Power = (Close price – Open price) / (High price – Low price)
Balance of Power could be used to generate trading signals on the crossovers
with its centerline.
It means buy when BOP crosses above zero line (becomes positive
) and sell when BOP crosses below zero line (becomes negative).
A moving average can smooth the resulting value. The level or center line in
BOP represents a stock’s accumulation above or below its zero line. When the
indicator is in positive territory, bulls dominate, and sellers dominate when the
indicator is negative. A reading near the zero line indicates a balance between
the two and can mean a trend reversal.
3.6. Stochastic
Based on the observation, closing prices tend to be closer to the upper end
of the price range as prices increase. In case of a downtrend, the closing
prices tend to be closer to the lower end of the price range.
%K = (C-L) / (H-L) X 100
%K = Stochastic
C = Latest Close Price
L = Low price during last N Periods
H = High price during last N periods
Two lines, %K and %D, can generate the buy/sell indicators. A crossover
signal occurs when the two lines cross in the overbought region (commonly
above 80) or the oversold region (commonly below 20). It is considered a
sell indicator when a %K line crosses below the %D line in the overbought
region. Conversely, when an increasing %K line crosses above the %D line
in the oversold region, it is considered a buy indicator.
Negative divergence - When price makes higher peaks, and OBV fails to make
higher peaks, the upward trend is likely to fail.
Positive divergence - When price continues to make lower troughs, and OBV
fails to make lower troughs, the downward trend is likely to fail.
5. Volatility Indicators
5.1. Average True Range (ATR)
Average True Range or ATR is a measurement of volatility. It measures the
average of true price ranges over time. For example, if the system gives me an
ATR number of $1.75 for XYZ stock based on 15 days parameter, then it
means that the stock moved an average of $1.75 per day over the past 15
days. Thus, the indicator is used primarily to measure volatility.
High ATR values often occur at market bottoms or market tops following a
panic sell-off or aggressive buying. Low ATR values are usually found during
extended sideways movements or consolidation periods.
Trading Setups
You can develop your trading system based on your idea. Technical Analysis is a
science once can teach you technical indicators, their merits, demerits. However,
the use of these indicators for the prediction of trends/prices is an art. There could
be thousands of permutations and combinations of these technical indicators to
predict buy or sell signals. Our objective should be to develop a mechanical
trading system that gives a good return on past data and is expected to perform in
the future based on assumptions that past price behavior and pattern will continue
in the future.
The following steps can be used for the development of a profitable trading setup –
1. Idea
2. Analysis
3. Backtesting
The basic idea is to ride the trend, so my objective is to find stocks in an uptrend
and buy when momentum starts.
Strategy and Analysis – It is assumed that a stock trading above 200 moving
average is in a long-term uptrend. So I am selecting a stock only when they are in
a long-term uptrend. One can use the Oscillator to discover short-term overbought
or oversold conditions. So I am using RSI to predict a short-term trend. I will use
21 days RSI for generating buy and sell signals. So my strategy is to buy a stock
that is trading above 200 days moving average when 21 days RSI is above 70%
and sell when it's below 50%.
Coding and analysis for backtesting – In the following example, I have computed
returns generated by eight different stocks from different sectors to check the
strategy's performance with the help of Python (Python code of this program given
in book 'Python for trading on Technicals’).
We will get the following output –
As we can observe in the output, this strategy gives 12% to 98% returns in various
stocks with an average of 75 to 100 trades per stock. Maximum return in a single
trade is shown in column 'H', and maximum loss in a single trade is given in
column 'I'.
As I have taken two indicators Moving average and RSI, for the development of
this strategy in the above example, in the same way, you can take any
combination of 2 or more indicators for backtesting and development of your
strategy.
Cost of Trade
One more vital factor to consider is the cost of trade also. This cost of trade can
make any good strategy unprofitable.
In the following output, I have computed returns given by the above stocks on
different moving averages and different RSI values with the cost of trading. B
column is the Moving Average column, and the C column is the RSI period taken
for return computation. All values are per share –
You can develop your strategy in Python with different combinations of technical
indicators computed with different periods. I always feel Options spreads are
always better than trading the future. For example, buying an in-the-money option
along with selling an out-of-money option with equal time value will have a benefit
of limited risk and lower margins as compared to buying a necked future. You can
learn option strategies and backtesting in Python in my next book, 'Option Greeks,
Strategies & backtesting in Python’.
Trading Options on Technical –
As we discussed earlier, buying an ITM Call and selling an OTM Call is better than buying the Future, and buying ITM Put
and selling OTM put is better than selling the future in terms of cost, maximum loss, and margins. So spreads can be
bought in spite of buying or selling future when a trader is bullish or bearish. Different strategies are used in other market
conditions. To learn all techniques, kindly read my book 'Option Greeks, Strategies and backtesting in Python’ author Anjana
Gupta.
Market View Bullish (Bull Spread with buying ITM Call along with selling ATM Call)
Let's take an example to explain this. The Index is trading at 10000. The market view is bullish. If a trader buys an ITM call
strike 9600 at Rs 489/- along with selling an ATM call strike 10000 at 226, then maximum profit in this strategy will be Rs
136/- If the Index expires above 10000. The trader will make money if the Index closes above 9863/-, so the trader is
making money even if the view is wrong. The maximum loss in this spread is limited to the net premium of Rs 263/- paid if
Index close below 9600.
In case of sudden fall in underlying, loss of buyer of the future position will be huge. There is a risk of evaporation of capital
also. So you need big money for the mark to market margin. However, in case of options spread loss will be limited, you
need not to pay any MTM. If you observe, you will found that I bought the ITM option and sold the OTM option with an equal
time value, so Theta will not give any loss on options positions.
Market View Bearish (Bear Spread with buying ITM Put along with selling ATM Put)
Let's take an example to explain this. The Index is trading at 10000. The market view is bearish. If a trader is buying ITM,
Put strike 10400 at Rs 486/- along with selling ATM call strike 10000 at 243 than maximum profit in this strategy will be Rs
157/- If Index expires below 10000. The trader will make money if the Index closes below 10157/-, so the trader is making
money even if the view is wrong. The maximum loss in this spread is limited to the net premium of Rs 245/- paid if the Index
close above 10400.
Options strategy on breakout - Ratio Back Spread
Ratio back spread is used when we are expecting breakout upside or downside on technicals.
Back spread sells one option and buys two or more options with a lower premium of the same
underlying and expiration. A back spread is a trade that requires a substantial move, upward for a call-
back spread and downward for a put-back spread. If underlying does not move in our desired direction
and breakout fails, then also this strategy does not result in loss. But if the underlying moves only a
little, even though it moves in our desired direction, then a back spread can lose money.
Nifty Call Options closing price as of 2nd April 2018 are given below-
Currently, Nifty is trading at 10264, and the trader is expecting a significant upside. He can sell a Call
strike 10400 at Rs 80/- and buy two lots at Rs 47.25. So a trader is paying a premium of Rs 14.25/-.
The Breakeven point of this strategy will be 10614. The trader will lose 14.25 if the underlying will close
below the strike of 10400 sold. The loss will start to increase from 10400 to 10500. The trader will have
the highest loss at 10500 (strike at which options are bought). The trader will make money if the
underlying will close above 10614. Because one option sold and two options bought traders will make a
profit of Rs 1 on every Rs 1 increase in underlying price above 10614.
Any combination of strikes could be used for ratio back spread. A trader can also sell one lot of ATM strikes and buy two lots
of OTM strikes. Closing above OTM strike will give good profit.
Butterflies are directionless strategies. Seller of butterfly will make money underlying moves in either
direction upside or downside. Buyers will make money when prices remain in the range. So the bet is
not on direction but on price movement, whether there will be a significant move in prices in either
direction or not.
Long Butterfly
The long butterfly is a directionless strategy that seeks profit from time decay or decline in implied
volatility and Theta. Long butterfly constructed using the three strikes of fix interval, buying the lower
strike option, selling two middle strike options, and buying the higher strike option. The butterfly could
be constructed using either call or put.
Long butterfly in above example resulting into the net debit of Rs. 14.80/-. The middle strike of a long
butterfly should be located in the middle of the expected trading range. Trader in the given example is
expecting a Nifty closing near 10000 on Expiry, so he sold two lots of Nifty call strike price 10000,
bought one lot of Nifty call strike price 9900, and bought one lot of Nifty call strike price 10100. Strike
price distance should be equal on both sides, i.e., one call trader bought is 100 points in the money,
and another call trader bought is 100 points out of money, so the distance from the middle strike is
equal on both sides. The value of this butterfly will remain in the range of 0 to 100 irrespective of the
underlying value (distance among two strikes). Buying butterfly resulted in a net debit of 14.80, so the
maximum loss is limited to Rs 14.80/-. Maximum profit is limited to Rs 85.20/- (Strike interval of 100
minus net debit of Rs 14.75 equals Rs. 85.20/-).
The profit and loss on the expiration matrix are given below. The trader will make the highest profit if
the Index expires on 10000. The trader will make money if the Index closes in the range of 9915 to
10085. If the Index closed below 9900 or above 10100, then the trader will lose Rs. 14.80/- paid initially
to buy butterfly. So the maximum loss is limited to the premium of butterfly RS 14.80 paid.
Short Butterfly
Short butterfly constructed using the three strikes of fix interval, selling the lower strike option, buying
two middle strike options, and selling the higher strike option. The butterfly could be constructed using
call or put.
This is just the opposite of a long butterfly. This strategy results in a net credit of Rs 14.80/- so the
maximum profit is limited to Rs14.80. However, the maximum loss is limited to Rs 85.20/- (Strike
interval of 100 – premium received of Rs 14.80 = 85.20). The trader will earn Rs 14.80 if Index close
below 9900 or above 10100.
In the above example trader constructed butterfly by selling two calls of Nifty strike 10000 and buying
one on both sides on fix the price difference. In the same way, a trader can construct butterfly at
different strikes of Nifty.
For example, a trader can construct a butterfly at 9900 by buying one lot of 9800 Call, selling two lots of
9900 Call, and buying one lot of 10000 Call.
A trader can construct a butterfly at 10100 by buying one lot of 10000, selling two lots of 10100, and
buying one lot of 10200.
An example of a 100 point Butterfly of Nifty constructed at different strikes is given below. Please note
theoretical prices are taken when nifty is trading at 10000, and there are 25 days to Expiry. 100 point
butterfly of 9600 resulting in a debit of Rs 3.7/- (Buy one lot of 9500 Call at 546.9, Sell two lot of 9600
Call at 450.10 and buy one lot of 9700 call at 357). In the same way, 100 points 9700 butterfly is
resulting into the net debit of Rs 6.40/-, 100 point 9800 butterfly resulting into the debit of Rs 9.9/- and
so on.
Nifty 100 Butterfly Prices when Index is 10000 and 25 days to Expiry
In the above example Index is trading at 10000, and there are 25 days to Expiry. As the Expiry nears,
the price of butterflies will increase marginally. ATM butterfly will increase more, and OTM and ITM
butterfly will increase less, but there will be an increase in price till 8 to 10 days of Expiry. When there
are only 7-8 days to Expiry, the ATM, ITM1, and OTM1 butterfly value will move towards 100 very fast.
On Expiry day only ATM butterfly will be 100 rests all butterfly will be zero.
Prices of Nifty point 100 Butterfly on Expiry when Index is 10000 are given in below table -
Strike Butterfly
Price 9500 9600 9700 9800 9900 10000 10100 10200 10300 10400 10500 Price
9600 500 400 300 0
9700 400 300 200 0
9800 300 200 100 0
9900 200 100 0 0
10000 100 0 0 100
10100 0 0 0 0
10200 0 0 0 0
10300 0 0 0 0
10400 0 0 0 0
You can observe that the butterfly of 10000, trading at Rs 14.8/- when there were 25 days to Expiry, is
now on expiry day closed at 100, and the rest all butterfly has become zero.
Let's take an example with past data for better understanding. I have taken the Nifty Future and
Options closing price of Jan 2017. Please refer to the below table. The first column is the date the
second column is the nifty closing price; on 30th Dec 2016 Nifty closing price was 8187. The 3rd to 9th
columns are prices of butterfly of various strikes computed based on the closing price on that date.
For example, on 30th December, the Nifty 8100 butterfly was trading at Rs 12.8. Nifty strike 8000
closing price was 244.5, strike 8100 closing price was 170.5, and strike 8200 closing price was 109.3.
Compute the price of 8100 butterfly buy one lot strike 8000, sell two lots of 8100 and buy one lot of
8200. (244.5-170.5-170.5+109.3=12.80/-)
In the same way, the prices of other butterfly are computed. If one will buy the butterfly at 12.80, then
the maximum loss is limited to Rs 12.80, and the maximum profit is limited to Rs 87.20.
If you observe Butterfly prices in the following table, the most expensive butterfly was strike 8200
trading at 15.7 on 30th December 2016, Nifty was trading at 8187.
On 10th January, Nifty price goes up to 8294; the most expensive butterfly was strike 8300 tradings at
19.3/-.
On 25th Jan 2017, Nifty closed at 8599. You will check the highest price of the butterfly is 94.9 of option
strike 8600 (computed based on closing price).
Butterfly strike 8100, trading at 12.80 on 30th December 2016, came down to zero by the end of the
month on Expiry. On the other hand, strike 8600 butterfly, trading at Rs 5.2/- on 30th December 2016,
goes up to 94.90 on expiry day.
In the following table, you will also observe that in the initial day's butterfly prices increasing gradually
by one or Rs 2 in every 2-3 days. Buy if you will check the last week on 20th Jan highest price butterfly
was 33, on 23rd Jan 41.70, on 24th Jan 55.9/- so prices are increasing very fast.
In the initial day's price movement is less, so the risk is less, whereas when Expiry nears, price
movement is fast, so the risk of the trading butterfly is more. Day-wise strike wise Nifty 100 point
butterfly computed from closing prices of options are given in the following table.
This is a very subjective area. Each trader can have a different view on trading butterfly based on their
experience. Let's take one more example. In the last table, I have taken data of 100 point butterfly;
now, in the following table, I am taking data of 200 point butterfly of Jan 2017 itself. Key points to note –
- Nifty is trading at 8187; strike 8200 butterfly is trading at 59. It's a 200 point butterfly, so the
butterfly's value will remain between zero to 200. So for the buyer of butterfly maximum risk is
Rs 59, and the maximum profit is limited to Rs 141.
- Buyer of 8200 butterfly will make a maximum profit if underlying close at 8200 on Expiry. The
breakeven point on the upside is 8341, and the breakeven point on the downside is 8059. So
the buyer will make money if the Index will close somewhere between 8059 to 8341.
- In the same way seller of the butterfly will have a maximum risk of Rs 141, profit
will be limited to 59. The seller would make money if the Index closed above 8341 or below
8059.
Traders need not to take a view on direction; that's why it's a direction neutral strategy.
So if you think the market will range-bound will remain at the same level till Expiry, you will buy
a butterfly, and if you think the market could move downside or upside from the current level,
you will sell a butterfly. On the initial day's risk is less, but near Expiry, prices of butterfly
become volatile. Day-wise strike wise Nifty 200 point butterfly computed from closing prices of
options are given in the following table.
Greeks – I have taken an example of a long butterfly strike 8200 to explain the Greeks.
Theta of the butterfly is positive, so that that time decay will help the option buyer. We have taken ATM
butterfly in the above example; that's why Vega is negative -4.95. In the given example, the trader is
buying 8200 butterfly at Rs 59/-, if implied volatility fell by 1%. The price of the butterfly will increase by
Rs 5/- from 59 to approx 64 if other variables remain the same.
Underlying
Price Delta Vega
7700 0.00 2.15
7800 0.02 1.99
7900 0.15 0.34
8000 0.49 -2.41
8100 0.56 -4.69
8200 -0.05 -4.95
8300 -0.57 -3.04
8400 -0.44 -0.31
8500 -0.13 1.70
8600 -0.02 2.36
8700 0.00 2.00
Greeks of butterfly will depend on the location of butterfly. You will notice in the above table that if the
center strike of the butterfly is above ATM (8200), then delta is negative, and if the middle strike of the
butterfly is below ATM, then delta is positive. Next, check the Vega with respect to the underlying price
in the above table. You will find the Vega of the ATM butterfly is negative, but if will go for a butterfly
below the lower wing (strike 8000) or above the upper wing (strike 8400), then Vega of the butterfly is
positive.
So how to trade butterfly will depend on the stock you are trading and the technical indicators
you are using. With the help of Python, you can backtest both. Please refer to my other books
for backtesting and development of your strategy.
Why Python
With the help of Python, one can try to develop technical based trading systems
that are consistently profitable in various market conditions. When we talk about
systematic trading, it means all decisions of buy and sell will be taken by the
system, not by the intuition of the individual. The system will generate a buy and
sell signal. We also need to check that these systems are profitable on past data
or not. Trading is all about making money. Algorithmic trading is all about
developing quantitative rules that give you profit. With the help of Python, you will
be able to create, modify and backtest your idea on past data to develop your
profitable strategy. Your ideas should be based on common sense, and then
Python can help you to get your ideas tested using historical data to be sure they
work.
Strategies in Excel
You need not to prepare an Excel sheet for the computation of strategies payout.
Many readymade excel worksheets format for option Greeks and payout
computation are available on Google free of cost; you can search and download.
One of the Excel is available on the following link –
https://www.softpedia.com/get/Others/Finances-Business/Option-Trading-
Workbook.shtml
With the help of the above excel, you can compute the Greeks, Breakeven point,
combined profit and loss of various combinations of contracts on Expiry, profit, and
loss of options contract before Expiry for any combination of your choice –
Some tips are also given there.
Books by This Author
1. First part cover option Greeks - Delta, Gamma, Theta, Vega, Delta
hedging & Gamma Scalping, implied volatility with the example of past
closing prices of Nifty/USDINR/Stocks (Basics of Future and options
explain).
2. Second part covers option trading strategies with examples of
Nifty/USDINR options and computation of returns of a strategy on past
data. (You will get an idea of how professional traders think)
3. Third part covers Python for traders. After reading this book, a novice
trader will also be able to use Python from the installation of Anaconda
on his laptop & extracting past data to backtesting and developing his
strategies. Python is explained from very basic so that anyone who does
not have an in-depth understanding of programming can understand and
develop codes. How to fetch past daily data, per minute data, live data
for backtesting & development of strategies explained. Many program
codes and their results also explained for backtesting of strategies likes
ratios, butterfly, etc.
Most of the trading strategies are explained with historical per minute
data Nifty and Bank Nifty weekly options.
About Authors / Acknowledgments
Anjana Gupta, I am the author of this book. I am having a master degree in
science and management. I am having more than ten years of experience. Special
thanks to Puneet Kanwar, who was instrumental in the completion and editing of
this book. Puneet Kanwar is having experience of 15 years in the Indian capital
market. He has worked with BSE Limited, formally known as Bombay Stock
Exchange, for six years. He has also worked with a prestigious broking house,
Edelweiss, before BSE. In 2017 Puneet resigned from BSE for his venture.
Currently, he is a successful options trader and arbitrager.
For feedback/suggestions/query/doubt, you can write to me at
optionsnpython@gmail.com.
Happy Learning.
Anjana Gupta