Low Risk Options Trading Strategy - Option Spreads

[prashyrao]

Thanks SS for sharing your trading approach with us.
I use slight variation of this to limit my risk of futures trade. During mkt hours my futures positions carry stoploss to manage risk. At EOD, I hedge them by selling double quantity of options. eg. If 1 lot I am long NF, then near mkt close, I will sell 2 lot ATM nifty calls.
This reduces the risk of Gap open. By doing this, I am reducing the DELTA +1 of NF with (-1)*2*0.5 from short CALL. On next trading day, I will squareoff the sold call and use Stops on NF. On many days, I end up collecting small profit after brokerage on my short call position while NF still remains in stoploss range. Otherwise, the broekrage on 1 short call trade is the price I pay for my one night's sound sleep.

Happy Trading

What if there is an extreme opening, 2-3% up or down?

 

[myvineet]

What if there is a gap-down, say 2%? And a news induced volatility?

then we will get out from futures position which is long & trail the position down in calls ,acc to inputs from charts.

so the loss in long future will be compensated by the short calls ...

thanx

 

[samip2u]

2) Lets take an example and construct a spread trade.
First we need to have some idea about the market direction (doesn't matter even if we are proven wrong. nobody is 100% right here) - so as per our current analysis, we find that market is going down since budget day. And we believe that it is going to go down further. That means we want to take bearish position. Our analysis also suggest that market can fall to 3800 level. For simplicity, lets use PUT options to trade.

Direction - Bearish
Construction - Buy 1 - PUT option strike 4000, and Sell 1 - PUT option strike 3900
Cost of trade (or net premium)= taking Friday (9/July price for July expiry) = to buy 4000 Put we have to pay 144 and when we sell 3900 Put market gives us 97.
so our net cost 144 - 97 = 47/-
Max Risk = 47
Max Reward = 4000 - 3900 = 100 rs.
Break-even point = 4000 - 47 = 3953. (that means, if market closes anywhere below 3953, we will be +ive on this trade. If it closes below 3900 we will get max reward of 100 pts. If market closes above 4000 then we will loose 47 which is max that we have put in this trade from our pocket)

Happy Trading

Some clarification requested on the above spread strategy..
I understand that, using spreads we are limiting or risk and returns...But how do we arrive at the Breakeven value of 3953, thought it looks simple 3953 = 4000-47!

Lets analyse the options in diff situations.
Initially... we have
LONG PUT with strike 4000 @144 ( breakeven at 4000-144 = 3856)
SHORT PUT with strike 3900 @97 ( break even at 3900-97 = 3803)

Three possive scenarios...

1.) Nifty ( say @3900) > 3856
LONG PUT position is at loss ( -44)
SHORT PUT position at profit( +97)

Net possible profit = -44+97 = +53 ( change in intrinsic value, as time value shd be almost nil in option spread strategy)

2.) 3803 < Nifty(Say @3830 ) < 3856
LONG PUT at profit ( 3856-3830= +26)
SHORT PUT at profit ( 3830-3803 = +27)

Net profit = +26+27 = 53

3. ) Nifty( say @3750 ) < 3803
LONG PUT at profit ( 3856-3750 = +94)
SHORT PUT at loss ( 3750-3803 = -53 )

Net profit = +94-53 = +41


So... i am not getting how did you arrive athe break-even of 3953.... and saying thats the maximum profit is +100

In all calc. i have not adjusted the brokerages...

Pls clarify....

 

[NiftyFantasy]

some clarification requested on the above spread strategy..
I understand that, using spreads we are limiting or risk and returns...but how do we arrive at the breakeven value of 3953, thought it looks simple 3953 = 4000-47!

Lets analyse the options in diff situations.
Initially... We have
long put with strike 4000 @144 ( breakeven at 4000-144 = 3856)
short put with strike 3900 @97 ( break even at 3900-97 = 3803)

three possive scenarios...

1.) nifty ( say @3900) > 3856
long put position is at loss ( -44)
short put position at profit( +97)

net possible profit = -44+97 = +53 ( change in intrinsic value, as time value shd be almost nil in option spread strategy)

2.) 3803 < nifty(say @3830 ) < 3856
long put at profit ( 3856-3830= +26)
short put at profit ( 3830-3803 = +27)

net profit = +26+27 = 53

3. ) nifty( say @3750 ) < 3803
long put at profit ( 3856-3750 = +94)
short put at loss ( 3750-3803 = -53 )

net profit = +94-53 = +41


so... I am not getting how did you arrive athe break-even of 3953.... And saying thats the maximum profit is +100

in all calc. I have not adjusted the brokerages...

Pls clarify....

??????????

 

[AW10]

What if there is an extreme opening, 2-3% up or down?

as mentioned by myvineet, it will not impact the position. As we are delta neutral or carrying very small delta, then impact of 100/150 pts will be loss in futures, but almost similar gain in short calls. So next day, close the futures (or reverse if required), and book profit in short call.

By the way, how frequently do we see 2/3% gap open ? These are beyond 2std dev type of scenario which occure hardly 5% of trading days. I can't think of any other smooth way of handling them and come out with just bruises when others are bleeding.

Happy Trading

 

[AW10]

Samip2u, you are unnecessarily complicating the calculation. Still let me clarify in yr language..

LONG PUT with strike 4000 @144 ( breakeven at 4000-144 = 3856)
SHORT PUT with strike 3900 @97 ( break even at 3900-97 = 3803)

Three possive scenarios...

1.) Nifty ( say @3900) > 3856
LONG PUT position is at loss ( -44)
SHORT PUT position at profit( +97)

Net possible profit = -44+97 = +53 ( change in intrinsic value, as time value shd be almost nil in option spread strategy)

Perfectly OK. You make 53 rs. for investment of 47.

2.) 3803 < Nifty(Say @3830 ) < 3856
LONG PUT at profit ( 3856-3830= +26)
SHORT PUT at profit ( 3830-3803 = +27)

Net profit = +26+27 = 53

You are wrong here. When nifty at 3830, 4000 put is worth 170 rs.
and 3900 put is worth 70 rs. You always calculate intrinsic value from strike price of option, not from your BE point. (plz recall the basic).
So you net value of position will be +170 - 70 = 100 rs. And u paid 47 for this position..giving u net gain of 53 rs.

3. ) Nifty( say @3750 ) < 3803
LONG PUT at profit ( 3856-3750 = +94)
SHORT PUT at loss ( 3750-3803 = -53 )

Net profit = +94-53 = +41

When nifty is at 3750, 4000 put is worth 250, and 2900 put is worth 150.
Net value of position = 100 still.

So... i am not getting how did you arrive athe break-even of 3953.... and saying thats the maximum profit is +100

Now lets put it in simple way.. Net what u paid is 144 - 97 = 47 rs. so in order to make any profit on this, the intrinsic value of position shd be >47.
i.e. if nifty at expiry is X then, 4000 - X > 47. giving u BE of 3953. Below 3953, this position is worth more then what u paid for..

Once nifty goes below 3900, yr obligation creatd by short leg starts coming into picture and that limits your gain to max 53 rs of profit as explained above in case 2 and 3. Whatever level nifty goes to, you are guranteed that your RIGHTS given by 4000 put is more then OBLIGATION created by 3900 PUT giving u net benefit of 100 points.

Hope this is clear now.

Happy Trading

 

[prashyrao]

as mentioned by myvineet, it will not impact the position. As we are delta neutral or carrying very small delta, then impact of 100/150 pts will be loss in futures, but almost similar gain in short calls. So next day, close the futures (or reverse if required), and book profit in short call.

By the way, how frequently do we see 2/3% gap open ? These are beyond 2std dev type of scenario which occure hardly 5% of trading days. I can't think of any other smooth way of handling them and come out with just bruises when others are bleeding.

Happy Trading

Hmmm, I see the logic here. Only time where one has to be careful I guess. is high volatility days, when there is huge whipsaw.

Just a side-step: it's very difficult to ge the first 100 points in your direction. If you are in the luck, then you can leg into different strategies ;-)

@myvineet: Thanks for the reply.

 

[AW10]

Hmmm, I see the logic here. Only time where one has to be careful I guess. is high volatility days, when there is huge whipsaw.

I don't think so cause here we are talking about Delta Neutral i.e. Market direction neutral position. That is the strength of option where with right strategy, u really don't care what is happening in the mkt. If one leg gains then other looses.. and at different time, other leg gains, the first leg looses.
What u need is the trust in your strategy.. and knowledge about how it will behave under different scenarios.

Happy Trading

 

[samip2u]

Samip2u, you are unnecessarily complicating the calculation. Still let me clarify in yr language..

Now lets put it in simple way.. Net what u paid is 144 - 97 = 47 rs. so in order to make any profit on this, the intrinsic value of position shd be >47.
i.e. if nifty at expiry is X then, 4000 - X > 47. giving u BE of 3953. Below 3953, this position is worth more then what u paid for..

Once nifty goes below 3900, yr obligation creatd by short leg starts coming into picture and that limits your gain to max 53 rs of profit as explained above in case 2 and 3. Whatever level nifty goes to, you are guranteed that your RIGHTS given by 4000 put is more then OBLIGATION created by 3900 PUT giving u net benefit of 100 points.

Hope this is clear now.

Happy Trading

Hi,

That was well explained AW10. I understand that.. paper trading is sumthing which one shd get into and follow it as seriously and religiously as the actual trade. But i hav a few things to know on the same.

1. How do we interpret the volatality of options market? i think, OI indicate the liquidity in the market. waht kinda thumb rule do traders normally use to weigh the market.

2. How delta is measured.. can we get the delta from NIFTY or any where. ?

3. technical analysis gives some Resistance and Support level to the index.. sometimes ppl claims its there at a strong support or not going to break the strong resistance. How do ppl claim that... does it help in options trading strategies?

4. options trading is more abt anticipating the nifty swings, what r the indicators which traders follow.. to anticipate a swing in the Index... global Sentiments ?

Lots of to questions.. please clarify....

 

[AW10]

1. How do we interpret the volatality of options market? i think, OI indicate the liquidity in the market. waht kinda thumb rule do traders normally use to weigh the market.

To keep it simple, use the VIX number published at NSE site. Check out the historical graph of VIX data.. and on relative terms, u will be able to tell if current VIX i.e. current option volatility is high or low.
I laugh when now-a-day people say that we are in volatile mkt. When VIX is between 20 to 25 which is on the lower side of the range, we are in most relaxed, smooth flowing market. Infact that is warning sign that people are complecent. And when fear comes in mkt, VIX starts going up. Thats when option premium also starts going up cause people run for hedging when they are woken up from the complecency..

2. How delta is measured.. can we get the delta from NIFTY or any where. ?

I am writing some thumb rules of Option Delta here, Hope this helps..
- Delta is measure of Change in Option Premium wrt to one Unit move of Underlying.
- Calls have +ive delta, and Puts have -ive delta
- ITM option have higher Delta. Deeper the ITM, higher the delta.
- ATM options have delta approx around 0.5
- Roughly, Delta indicates the probability of option expiring ITM. This justifies the higher Delta of deep ITM options cause they their delta of 0.92 indicates that 92% of chance, they will remain ITM.
- Futures / Stocks have Delta of +1 i.e. 1 Rs move in stock price will result in change in futures value by appox 1 Rs (give and take minor adjustment).

You will need option analysis tool to find out about the delta or other option greeks.

3. technical analysis gives some Resistance and Support level to the index.. sometimes ppl claims its there at a strong support or not going to break the strong resistance. How do ppl claim that... does it help in options trading strategies?

Tech Analysis is foundation of any trading. That will help u understand what mkt is doing now and what it may do next based on historical patterns. That gives edge to option trader in terms of selecting right option strategy for what is going to come next..
In TA there are guiding rules which helps in identifying the relative strength of a price level, trend line etc. Knowledge of these levels certainly helps in designing option strategy.
Say if there is strong support at 4920, i.e. whenever mkt came here, buyers came in and price could not go below that. So if I have to write a PUT, then it is safer to write 4900 put which has higher chance of expiring worthless.. then writing 5000 PUT which might end up ITM later.
Similarly, 5200 was strong resistance, cause price fell from that in last 3-4 occasion so that was a safer strike to write calls.
But these strong levels also starts getting weaker with each touch of price.. (like a strong wall may not fall by first hit of hammer but with few more strikes it eventually falls down).

4. options trading is more abt anticipating the nifty swings, what r the indicators which traders follow.. to anticipate a swing in the Index... global Sentiments ?

You can use different approaches to anticipate what is going to come next. I trust charts more then anything so I use that data (along with other mkt data published by exchange) to form my opinion about what is going to come next. In my view, you can't monitor global sentiments cause they are unlimited.. so better to focus on our energy which is manageable and form our analysis.
Lets accept the fact, that you can never be 100% perfect in your analysis.. even if you have the capabilities of search engine of Google to scan the world news. So plan our risk well, and learn to live with <100% analysis. How much less ? it is individuals choice.
My suggestions will be to use technical analysis to read the mkt. For option, Time is crucial factor hence, IMO, all the stuff of fundamental analysis, great mgmt of company etc is of no use in options trading.

Hope this helps.
Happy Trading