Low Risk Options Trading Strategy - Option Spreads

[anuragmunjal]

Dear Anurag,

I agree with the STT issue. But you would realise that most of traders would not leave even a profitable position open till expiry. At expiry one would close it just before the closing hours on expiry day. This would take care of your STT issue. Also for accounting and taxation closed position are easier to compute and for record maintenance.

Also setting a synthetic trade would allow one to exit one leg (mostly closing long Call 5400 earlier if the market moves back or move sideways) if one is convinced about the direction after setting this trade.

Regards,

hi tnsn
I was assuming here that the position that he has created was a hedge to his short 5500 ce and hence it is more likely that both go into expiry especially with 2-3 days to expiry.
moreover, if he tries to square off his 5400 ce just before the closing hours on expiry day, there is a big chance that his 5400 ce would be going @ around a 3-4 Re discount to nifty futures. now in a single lot it probably would not make much of a difference, but if the quantity is large, believe me it does make a big difference.

regards

 

[AW10]

Dear Anurag, any particular advantage for buying Futures over synthetic one? And when should he take this trade? Though Cool has now given it a pass, for academic interest if you could explain

Regards,

Dear tnsn, adding my 2 views on comparing futures v/s synthetic.

1) In case of future, we pay brokerage for 1 txn, whereas synthetics doubles this cost due to 2 legs.
2) stt issue as explained by Anurag affects synthetics (though only if txn goes into expiry)

3) Futures can be created at any price level but synthetics can be only at strike price i.e. xx00 levels.

4) Comparing them from option greeks perspective - theoretically, futures give us delta of 1. Synthetics give us delta on 1 only when it is ATM.. i.e. synthetic long of 5400 will have delta of 1 when spot is at 5400.. As spot moves up or down and synthetics get ITM/OTM, the delta drifts away from 1. Say when mkt @5700, 5400 short put would have lost most of its delta, and long 5400 call get delta of 0.85 to 0.95 or anything but not 1. Hence we got to adjust synthetics to keep us delta neutral.

5) squaring off for synthetics (when mkt falls and we are holding long synthetics) will be bit tricky and incur slippage due to closing of two independent txns whereas, it is one simple trigger order for futures. We have to place 2 orders and take the hit of bid/ask spread at two places. In other words, managing futures trade is easier then managing synthetics.
Comparatively options are less liquid to futures.. so when one talks about managing positions of significantly large size, futures can easily come few steps ahead of synthetics.

I can think of only these points at the moment. Hope this helps the discussion..

happy trading.

 

[sriugdh]

Dear tnsn, adding my 2 views on comparing futures v/s synthetic.

1) In case of future, we pay brokerage for 1 txn, whereas synthetics doubles this cost due to 2 legs.
2) stt issue as explained by Anurag affects synthetics (though only if txn goes into expiry)

3) Futures can be created at any price level but synthetics can be only at strike price i.e. xx00 levels.

4) Comparing them from option greeks perspective - theoretically, futures give us delta of 1. Synthetics give us delta on 1 only when it is ATM.. i.e. synthetic long of 5400 will have delta of 1 when spot is at 5400.. As spot moves up or down and synthetics get ITM/OTM, the delta drifts away from 1. Say when mkt @5700, 5400 short put would have lost most of its delta, and long 5400 call get delta of 0.85 to 0.95 or anything but not 1. Hence we got to adjust synthetics to keep us delta neutral.

5) squaring off for synthetics (when mkt falls and we are holding long synthetics) will be bit tricky and incur slippage due to closing of two independent txns whereas, it is one simple trigger order for futures. We have to place 2 orders and take the hit of bid/ask spread at two places. In other words, managing futures trade is easier then managing synthetics.
Comparatively options are less liquid to futures.. so when one talks about managing positions of significantly large size, futures can easily come few steps ahead of synthetics.

I can think of only these points at the moment. Hope this helps the discussion..

happy trading.

Hi AW10,

Sir, I have a doubt.

If an investor had originally purchased shares of XYZ for Rs 27. Subsequently, he writes a call for a premium of 1.50. If, during the expiry date, XYZ shares are trading at Rs 32 and the investor still manages to break even on his strategy, what must have been the exercise price on the calls involved?

Please say what will be the excercise price?

Regards,
Sri

 

[prashyrao]

Hi AW10,

Sir, I have a doubt.

If an investor had originally purchased shares of XYZ for Rs 27. Subsequently, he writes a call for a premium of 1.50. If, during the expiry date, XYZ shares are trading at Rs 32 and the investor still manages to break even on his strategy, what must have been the exercise price on the calls involved?

Please say what will be the excercise price?

Regards,
Sri

The only chance would be for the investor to have sold [email protected], which is only possible if XYZ had moved down to near or below 25.5. No body will write an option at the intrinsic value without premium. Now he receives his 27 bucks per share back (if that is what you meant by breakeven).
He would have enjoyed the full ride to 32 if he were to write [email protected] (ATM).

 

[prashyrao]

Can anybody answer the following question.

Why More Deep in the money call option value has less time value of money than less deep in the money call option value?

eg : according to Nifty options today:

Nifty value : 5414.3 , Expiry : 30th September

Strike price : 5000
Call premium : 488
Intrinsic value : 414.3
time value : 73.7

strike price : 5300
Call premium: 262
intrinsic value : 114.3
time value : 147.7

So is it better to always buy deepest in the money call option? Also delta of deep in the money option is quite high so the premium value moves faster when the market moves upwards.

Please comment

Real mathematical answer will have to deconstruct Black-scholes PDE So only an expert can give it to you.
I am only trying to answer your second question: is it good to buy deepest ITM? Only if the volatility is less! Since the outlay increases, %ROI would be less AND if the market moves against you heavily, you are risking more money.

 

[DanPickUp]

Hi varun.varma

Nice questions by the way.

""Why More Deep in the money call option value has less time value of money than less deep in the money call option value?""

Prashyrao has mentioned the Black-scholes formula, which is one of the different option pricing models and volatility.

I will explain here about the pricing of an option and I will explain some more on the impact the volatility has on options.

As a short repetition:

The premium is the price at which the contract trades. The premium is the price of the option and is paid by the buyer to the writer, or seller, of the option. In return, the writer of the call option is obligated to deliver the underlying
security to an option buyer if the call is exercised or buy the underlying security if the put is exercised. The writer keeps the premium whether or not the option is exercised.

The option price is constitued of 2 price components, the intrinsic value and the time value.

Option price = intrinsic value + time value

Intrinsic value: The intrinsic value of an option is the difference between the actual price of the underlying security and the strike price of the option.
The intrinsic value of an option reflects the effective financial advantage which would result from the immediate exercise of that option.

Call Option Intrinsic Value = Underlying Stock's Current Price – Call Strike Price
Put Option Intrinsic Value = Put Strike Price – Underlying Stock's Current Price

The time value of options is the amount by which the price of any option exceeds the intrinsic value.
It is directly related to how much time an option has until it expires as well as the volatility of the stock.
The formula for calculating the time value of an option is:

Time Value = Option Price – Intrinsic Value

As an example : Call premium is 488. Intrinsic value is 414.3

488 - 414.3 = 73.7

262 - 114.3 = 147.7

So you got the exact answer now for both of your options time value

---------------------------------------

Now to the volatility :

This options you show have a longer time to expiration. Volatility has a bigger impact to them, then to options which are near expiration.

Also volatility has a bigger impact to out of the money options then to in the money options. The least impact volatility has is to options at the money.

--------------------------------------------------------

""Is it best to always buy deepest in the money options?""

No.

First, it depends again on your strategy.

You can trade diagonal spreads with deep in the money options which are far away from expiry dates. I know Option traders, which only live from such option trading strategies. They do nothing else and have a quite live. Watching a few times in the day the market and adjust the trade if necessary. But you can trust me when I say : This stuff is not for beginners and even advanced option traders can get in trouble with the adjustments of such trades.

Instead deep in the money options, you also can trade direct the future and use the options for the hedges.

Delta for any future is one. If you want to trade deep in the money options, which have a delta near one, so why not take directly the future with a stop loss ?

Take care

DanPickUp

 

[simple_trader]

Can anybody answer the following question.

Why More Deep in the money call option value has less time value of money than less deep in the money call option value?

eg : according to Nifty options today:

Nifty value : 5414.3 , Expiry : 30th September

Strike price : 5000
Call premium : 488
Intrinsic value : 414.3
time value : 73.7

strike price : 5300
Call premium: 262
intrinsic value : 114.3
time value : 147.7

So is it better to always buy deepest in the money call option? Also delta of deep in the money option is quite high so the premium value moves faster when the market moves upwards.

Please comment

As Dan has mentioned, it is better to trade future with appropriate SL than deep ITM option. You do not have any additional advantage, rather you have a couple of disadvantages like -

1. You are paying 70 points time value with no added advantage compare to future contract.

2. Also, the same time value can give you no return even if price goes in your favor, like if price goes 80 points against your position and then 100 points in favor. Then net basis, you should be in 20 points profit, but in case of option even it can show you loss instead of profit.

Happy trading!

 

[DanPickUp]

Hi

This post is edited and updated :

http://www.traderji.com/options/305...g-strategy-option-spreads-116.html#post456722

I did not explain the black and scholes formula in its detail. I guess, this would be to complicate.

I give the explanation to an easy way of calculating the numbers.

It is a simple and easy way to understand the given numbers from the exchange.

Simple option pricing should be clear now to every one.

If you think, you want to go deeper into the math of financial derivatives, you can read here a whole book about it. It is from the University of Cambridge
(England) and was written in 1995. What is written in the book, is still used today and the use of the link is legal and free :

http://www.scribd.com/doc/10055859/Finance-The-Mathematics-of-Financial-Derivatives

Take care

DanPickUp

 

[Talon]

Vega
If there's a jump in vega, should we write option or wait for the vega to cool, as I have seen vega jumping before the underlying moves decisively?
BTW what the difference between vega and IV?
-Talon

 

[DanPickUp]

Hi Talon

"What is the different between vega and IV ?"

The Vega of an option indicates how much, theoretically at least, the price of the option will change as the implied or statistical volatility of the underlying asset changes.

Vega is quoted to show the theoretical price change for every 1 percentage point change in volatility. For example, if the theoretical price is 2.5 and the Vega is showing 0.25, then if the volatility moves from 20% to 21% the theoretical price will increase to 2.75.

Vega is most sensitive when the option is at-the-money and tapers off either side as the market trades above/below the strike.

Notice that the behaviour of an option Vega is similar to Gamma: increasing as the option moves from being in-the-money to at-the-money where it reaches its peak and then decreases as the option moves out-of-the-money.

"Should you write or not when vega jumps" ?

There is not a yes or no. It again depends on the circumstances this jump happens. As it is related to the the volatility, check the reason for : Why did the volatility rise or lower ?

Did it rise, because there is for an example a crash or maybe a break out of a range or what ever ? Is there a change, that the volatility goes quick back to lover levels, will the volatility stay at the same level or will it even more rise ?

This is the outlook, in a simple way explained, you will have to make when deciding if you go for a write or not. There can be more reasons to write an option, like depending on your trading plan and more.

Take care

DanPickUp