## 22.1 – Why now?

I suppose this chapter’s title may confuse you. After rigorously going through the options concept over the last 21 chapters, why are we now going back to “Call & Put Options” again? In fact we started the module by discussing the Call & Put options, so why all over again?

Well, this is because I personally believe that there are two learning levels in options – before discovering option Greeks and after discovering the option Greeks. Now that we have spent time learning Option Greeks, perhaps it is time to take a fresh look at the basics of the call and put options, keeping the option Greeks in perspective.

Let’s have a quick high-level recap –

- You buy a Call option when you expect the underlying price to increase (you are out rightly bullish)
- You sell a Call option when you expect the underlying price not to increase (you expect the market to either stay flat or go down but certainly not up)
- You buy a Put option when you expect the underlying price to decrease (you are out rightly bearish)
- You sell a Put option when you expect the underlying price not to decrease (you expect the market to stay flat or go up but certainly not down)

Of course the initial few chapters gave us an understanding on the call and put option basics, but the agenda now is to understand the basics of call and put options keeping both volatility and time in perspective. So let’s get started.

## 22.2 – Effect of Volatility

We know that one needs to buy a Call Option when he/she expects the underlying asset to move higher. Fair enough, for a moment let us assume that Nifty is expected to go up by a certain percent, given this would you buy a Call option if –

- The volatility is expected to go down while Nifty is expected to go up?
- What would you do if the time to expiry is just 2 days away?
- What would you do if the time to expiry is more than 15 days away?
- Which strike would you choose to trade in the above two cases – OTM, ATM, or ITM and why would you choose the same?

These questions clearly demonstrate the fact that buying a call option (or put option) is not really a straightforward task. There is a certain degree of ground work required before you buy an option. The ground work mainly revolves around assessment of volatility, time to expiry, and of course the directional movement of the market itself.

I will not talk about the assessment of market direction here; this is something you will have to figure out yourself based on theories such as technical analysis, quantitative analysis, or any other technique that you deem suitable.

For instance you could use technical analysis to identify that Nifty is likely to move up by 2-3% over the next few days. Having established this, what would you do? Would you buy an ATM option or ITM option? Given the fact that Nifty will move up by 2-3% over the next 2 days, which strike gives you maximum bang for the buck? This is the angle I would like to discuss in this chapter.

Let’s start by looking at the following graph, if you recollect we discussed this in the chapter on Vega –

The graph above depicts how a call option premium behaves with respect to increase in volatility across different ‘time to expiry’ time frames. For example the blue line shows how the call option premium behaves when there are 30 days to expiry, green for 15 days to expiry, and red for 5 days to expiry.

With help of the graph above, we can arrive at a few practical conclusions which we can incorporate while buying/selling call options

- Regardless of time to expiry, the premium always increases with increase in volatility and the premium decreases with decrease in volatility
- For volatility to work in favor of a long call option one should time buying a call option when volatility is expected to increase and avoid buying call option when volatility is expected to decrease
- For volatility to work in favor of a short call option, one should time selling a call option when volatility is expected to fall and avoid selling a call option when the volatility is expected to increase

Here is the graph of the put option premium versus volatility –

This graph is very similar to the graph of call premium versus volatility – therefore the same set of conclusions hold true for put options as well.

These conclusions make one thing clear – buy options when you expect volatility to increase and short options when you expect the volatility to decrease. Now the next obvious question is – which strike to choose when you decide to buy or sell options? This is where the assessment of time to expiry comes into play.

## 22.3 – Effect of Time

Let us just assume that the volatility is expected to increase along with increase in the underlying prices. Clearly buying a call option makes sense. However the more important aspect is to identify the right strike to buy. Infact when you wish to buy an option it is important to analyze how far away we are with respect to market expiry. Selection of strike depends on the time to expiry.

Do note – understanding the chart below may seem a bit confusing in the beginning, but it is not. So don’t get disheartened if you don’t get it the first time you read, just give it another shot

Before we proceed we need to get a grip on the timelines first. A typical F&O series has about 30 days before expiry (barring February series). To help you understand better, I have divided the series into 2 halves – the first half refers to the first 15 days of the series and the 2^{nd} half refers to the last 15 days of the F&O series. Please do keep this in perspective while reading through below.

Have a look at the image below; it contains 4 bar charts representing the profitability of different strikes. The chart assumes –

- The stock is at 5000 in the spot market, hence strike 5000 is ATM
- The trade is executed at some point in the 1
^{st}half of the series i.e between the start of the F&O series and 15^{th}of the month - We expect the stock to move 4% i.e from 5000 to 5200

Given the above, the chart tries to investigate which strike would be the most profitable given the target of 4% is achieved within –

- 5 days of trade initiation
- 15 days of trade initiation
- 25 days of trade initiation
- On expiry day

So let us start from the **first chart** on the left top. This chart shows the profitability of different call option strikes given that the trade is executed in the first half of the F&O series. The target is expected to be achieved within 5 days of trade execution.

Here is a classic example – today is 7^{th} Oct, Infosys results are on 12^{th} Oct, and you are bullish on the results. You want to buy a call option with an intention of squaring it off 5 days from now, which strike would you choose?

From the chart it is clear – when there is ample time to expiry (remember we are at some point in the 1^{st} half of the series), and the stock moves in the expected direction, then all strikes tend to make money. However, the strikes that make maximum money are (far) OTM options. As we can notice from the chart, maximum money is made by 5400 and 5500 strike.

**Conclusion** – When we are in the 1^{st} half of the expiry series, and you expect the target to be achieved quickly (say over few days) buy OTM options. In fact I would suggest you buy 2 or 3 strikes away from ATM and not beyond that.

Look at the **2 ^{nd} chart (top right)** – here the assumption is that the trade is executed in the 1

^{st}half the series, the stock is expected to move by 4%, but the target is expected to be achieved in 15 days. Except for the time frame (target to be achieved) everything else remains the same. Notice how the profitability changes, clearly buying far OTM option does not makes sense. In fact you may even lose money when you buy these OTM options (look at the profitability of 5500 strike).

**Conclusion** – When we in the 1^{st} half of the expiry series, and you expect the target to be achieved over 15 days, it makes sense to buy ATM or slightly OTM options. I would not recommend buying options that are more than 1 strike away from ATM. One should certainly avoid buying far OTM options.

In the **3 ^{rd} chart (bottom left)** the trade is executed in the 1

^{st}half the series and target expectation (4% move) remains the same but the target time frame is different. Here the target is expected to be achieved 25 days from the time of trade execution. Clearly as we can see OTM options are not worth buying. In most of the cases one ends up losing money with OTM options. Instead what makes sense is buying ITM options.

Also, at this stage I have to mention this – people end up buying OTM options simply because the premiums are lower. Do not fall for this, the low premium of OTM options creates an illusion that you won’t lose much, but in reality there is a very high probability for you to lose all the money, albeit small amounts. This is especially true in cases where the market moves but not at the right speed. For example the market may move 4% but if this move is spread across 15 days, then it does not make sense holding far OTM options. However, far OTM options make money when the movement in the market is swift – for example a 4% move within 1 or say 2 days. This is when far OTM options moves smartly.

**Conclusion** – When we are at the start of the expiry series, and you expect the target to be achieved over 25 days, it makes sense to buy ITM options. One should certainly avoid buying ATM or OTM options.

The **last chart (bottom right)** is quite similar to the 3^{rd} chart, except that you expect the target to be achieved on the day of the expiry (over very close to expiry). The **conclusion** is simple – under such a scenario all option strikes, except ITM lose money. Traders should avoid buying ATM or OTM options.

Let us look at another set of charts – the idea here is to figure out which strikes to choose given that the trade is executed in the 2^{nd} half of the series i.e at any point from 15^{th } of the month till the expiry. Do bear in mind the effect of time decay accelerates in this period; hence as we are moving closer to expiry the dynamic of options change.

The 4 charts below help us identify the right strike for different time frames during which the target is achieved. Of course we do this while keeping theta in perspective.

**Chart 1 (top left)** evaluates the profitability of different strikes wherein the trade is executed in the 2^{nd} half of the series and the target is achieved the same day of trade initiation. News driven option trade such as buying an option owing to a corporate announcement is a classic example. Buying an index option based on the monetary policy decision by RBI is another example. Clearly as we can see from the chart all strikes tend to make money when the target is achieved the same day, however the maximum impact would be on (far) OTM options.

Do recall the discussion we had earlier – when market moves swiftly (like 4% in 1 day), the best strikes to trade are always far OTM.

**Conclusion** – When you expect the target to be achieved the same day (irrespective of time to expiry) buy far OTM options. I would suggest you buy 2 or 3 strikes away from ATM options and not beyond that. There is no point buying ITM or ATM options.

**Chart 2 (top right)** evaluates the profitability of different strikes wherein the trade is executed in the 2^{nd} half of the series and the target is achieved within 5 days of trade initiation. Notice how the profitability of far OTM options diminishes. In the above case (chart 1) the target is expected to be achieved in 1 day therefore buying (far) OTM options made sense, but here the target is achieved in 5 days, and because the trade is kept open for 5 days especially during the 2^{nd} half of the series, the impact of theta is higher. Hence it just does not make sense risking with far OTM options. The safest bet under such a scenario is strikes which are slightly OTM.

**Conclusion **– When you are in the 2^{nd} half of the series, and you expect the target to be achieved around 5 days from the time of trade execution buy strikes that are slightly OTM. I would suggest you buy 1 strike away from ATM options and not beyond that.

**Chart 3 (bottom right) and Chart 4 (bottom left) **– both these charts are similar expect in chart 3 the target is achieved 10 days from the trade initiation and in chart 4, the target is expected to be achieved on the day of the expiry. I suppose the difference in terms of number of days won’t be much, hence I would treat them to be quite similar. From both these charts we can reach 1 **conclusion** – far OTM options tend to lose money when the target is expected to be achieved close to expiry. In fact when the target is achieved closer to the expiry, the heavier the far OTM options bleed. The only strikes that make money are ATM or slightly ITM option.

While the discussions we have had so far are with respect to buying a call option, similar observations can be made for PUT options as well. Here are two charts that help us understand which strikes to buy under various situations –

These charts help us understand which strikes to trade when the trade is initiated in the first half of the series, and the target is achieved under different time frames.

While these charts help us understand which strikes to trade when is the trade is executed in the 2^{nd} half of the series and the target is achieved under different time frames.

If you go through the charts carefully you will realize that the conclusions for the Call options holds true for the Put options as well. Given this we can generalize the best practices for buying options –

Position Initiation |
Target Expectation |
Best strike to trade |
---|---|---|

1st half of the series | 5 days from initiation | Far OTM (2 strikes away from ATM) |

1st half of the series | 15 days from initiation | ATM or slightly OTM (1 strike away from ATM) |

1st half of the series | 25 days from initiation | Slightly ITM options |

1st half of the series | On expiry day | ITM |

2nd half of the series | Same day | Far OTM (2 or 3 strikes away from ATM) |

2nd half of the series | 5 days from initiation | Slightly OTM (1 strike away from ATM) |

2nd half of the series | 10 days from initiation | Slightly ITM or ATM |

2nd half of the series | On expiry day | ITM |

So the next time you intend to buy a naked Call or Put option, make sure you map the period (either 1^{st} half or 2^{nd} half of the series) and the time frame during which the target is expected to be achieved. Once you do this, with the help of the table above you will know which strikes to trade and more importantly you will know which strikes to avoid buying.

With this, we are now at the verge of completion of this module. In the next chapter I would like to discuss some of the simple trades that I initiated over the last few days and also share my trade rationale behind each trade. Hopefully the case studies that I will present in the next chapter will give you a perspective on the general thought process behind simple option trades.

### Key takeaways from this chapter

- Volatility plays a crucial role in your decision to buy options
- In general buy options when you expect the volatility to go higher
- Sell options when you expect the volatility to decrease
- Besides volatility the time to expiry and the time frame during which the target is expected to be achieved also matters

Very good information sir.. thanks a lot and I am very curious to know ur trades..

You will get to know in the next chapter 🙂

Awesome. Had a few queries regarding the suitable strikes for various trades, while going through the previous chapters. This chapter cleared almost all of my queries. Thanks. 😀

Glad to know 🙂

Hey Karthik! Awesome man. After research on different brokers, I joined Zerodha a month back. Either I wasn’t introduced to Varsity or I overlooked it. You guys are rocking. I was searching everywhere on internet about trading info and strategies and accidentally came across Varsity and that ended my search. Nowhere I could find all the information so compiled, thorough and simplified.

Your hard work is very much appreciated. Keep the good work going.

Waiting eagerly for next module.

Viren, thanks so much for the kind words 🙂

Please do stay tuned for more on Varsity!

Very important info or I will say it is extract of the full module in a very practical way. Thanks a lot for that. Actually about a year back I was trying to understand the same thing by looking at historical data on NSE site and copying them to excel and doing some calculation. But was very tedious and I left in between without any success. It is nice that you gave in a perfect form.

* option shorting has been covered in earlier chapters but can it more explained the way log options are explained?

* What is high or low for volatility based on which we can judge chances of volatility movement. I mean to say if volatility is already high then its chances of going up may not be high even some trigger in near future. Market must have already considered the volatility factor.

* Is it possible that spot prices may go up but the the volatility will come down? Then what to do in options?

I think you had promised to give one case starting from the TA and /or FA to option and showing option trade taking place. Will it come in the next chapter.

Waiting eagerly for next chapter and next module.

Thanks

R P HANS

1) Is there anything specify you are looking at when shorting options? I suppose most of it has been explained.

2) For nifty Vix ard 17-18% is considered normal. You can keep this as reference value.

3) The next chapter has few case studies.

I thought option shorting also may be explained with graphs as is done for options long trade, showing pay off.

All 4 – Call long, Call short, Put long, and Put short has been explained.

sir,from next month futures margins r dramatocally increased,will it lead to increased option trading (bcoz retail traders cant afford that much marginsin fut so they may shift)i may be one among,clarify

Not sure Narsimha – we need to wait and watch.

Dear Karthik,

Another Brilliant chapter….Thanks a ton!……Maybe at this point, it may also be worthwhile to revisit Open interest in context of options. i.e how to interpret the current trading range using open interest information? It is widely believed (although maybe not necessarily true) that option writers control the option markets and therefore their action can give some indication of the likely short term market direction. Therefore the ability to interpret OI and its changing dynamics in the context of options may be useful?

In fact the whole theory of “options pain” stems from Options + OI concept. Will be discussing this in the next module.

Dear Sir,

I would earnestly request you to kindly clarify the following as per my understanding from Key takeaways of this chapter that :

(1) Buy options when I expect that the volatality will increase which in otherwords market will go down due to selling pressure . For suppose , if I buy call and put options both at same strike, call will go down and put will increase. And also

(2) Sell options when I expect volatality will decrease which in other words market will go up. If I sell call and put options both when I expect volatality will decrease, both call and put option values will increase after decrease of volatality. I will be very much thankful if you can kindly advise whether my is right or wrong and if my understanding is wrong, please enlighten about my observation. I sincerely hope you will guide me with suitable reply Sir. Awaiting eagerly for your advice in the matter.Thanking you very much. With Best Regards, God Bless you Sir, R.V.N.Sastry

1) Increased volatility does not mean market will go down

2)Likewise decrease in volatility does not really mean that the market will increase

Hi Zerodha, This is very help full information, thanks for sharing. I wanted to know about approx. what % people (out of total traded people ) actually make money in F&O trading? as i check on web i see very scattered info but more or less retailers most of the times (>70%) lose money badly. As an institution which does business on FO trading you should be having appropriate info.

Thanks in advance.

Ramu – all I can say is that Zerodha clients are few notches better than others 🙂

Dear karthik,if my question is irrelevant plz avoid,otherwise kindly reply,look below this is a screen shot of nifty today 9.53am,i have a doubt nifty futures October contract opening rate 8400,high rate8723.85,how this trade is possible at opening itself?except that rates 99.9% trade is in betwn 8350-8250 levels,earlier also this kind of odd trades seen in nifty..kindly clear my doubt

Quote As on Oct 26, 2015 09:53:04 IST

CNX Nifty – NIFTY

Open

8,400.00

High

8,723.85

Low

8,302.55

Ah, it must be one of those freak trades. Dont worry much about it.

Again appreciation for your decent work , waiting for Currency and Commodity lessons.

Getting there soon 🙂

Next chapter please……….

It live now.

Next Chapter please

http://zerodha.com/varsity/chapter/case-studies-wrapping-it-all-up/

What about squaring off the trade on the same day during the 1st half of the series? Which Strike should be selected?

2 strikes away from ATM should be good.

Hi Karthik,

I have a query..

As per today’s data, Nifty 8400 CE is trading at 31.25 and 8400PE is trading at 353.15..

My view is that Nifty spot will not cross 8400 till Nov expiry..

So, what should i do.. Sell 8400 CE and collect the premiums or Buy 8400 PE and hold till expiry..

I am confused.. Can u explain why and what i should do..

Selling a Put option is scary…I would suggest you sell CE instead. Alternatively you could just follow the strategy here http://zerodha.com/varsity/chapter/volatility-applications/

Hi Karthik,

Thnks for lessons. I have read your module 4 & 5.

I am new to trde.

Want to know how can i identify the target and % target(here 4% up).

thnks.

One of the best ways to identify target/SL is by analyzing the S&R regions. This chapter should help – http://zerodha.com/varsity/chapter/support-resistance/

Hi Karthik,

Thanks for sharing this wonderful tips.

However I have a question on settlement of options on expiry day. For example, assume I purchase Nifty 8000 [email protected] 15 – total qty 1000 on day before expiry. Nifty crashes on expiry day and ends at 7910. What will happen if I don’t sell the 8000 puts that I hold? Will it be auto squared off by zerodha? If not, what damages will I have to face as penality- excess chsrges/taxes?

Thanks,

Aravind

In this case you will be in profit of 8000 – 7910 – 15 = 75. Since you have not closed the position yourself, the exchange will do the settlement on your behalf. After deducting the taxes your profit money will be credited to you account. Also, if you are in such as situation its always advisable to close the position yourself instead of letting the exchange do this…to avoid the STT burden. More on this here – http://zerodha.com/z-connect/queries/stock-and-fo-queries/stt-options-nse-bse-mcx-sx

Hi Karthik,

Thanks for detailed chapters. I have read your module 4 & 5.

Request you please make it available in pdf format module 5.

It is now available in the PDF format. Please do check.

sir,

what is naked option ? please explain

When you buy/sell options without any hedge its called as a naked transaction. For example if I buy a cal option – its called a naked long on call option.

However something like a Bull Put Spread – http://zerodha.com/varsity/chapter/bull-put-spread/ is not a naked transaction as the trade has two legs.

Loved the subject Re introduction to CALL – PUT options and the decision making process regarding which strikes to buy based on the time frame. I would want a similar perspective on selecting which options to write based on the above guidlines. If you feel it is too much to give the detailing as above then please give us a few guidelines n how to proceed on the same which will help us make the calculations. I am sure it wll be of great help to all members here. Thanks.

Loved the subject Re introduction to CALL – PUT options and the decision making process regarding which strikes to buy based on the time frame. I would want a similar perspective on selecting which options to write based on the above guidlines. If you feel it is too much to give the detailing as above then please give us a few guidelines n how to proceed on the same which will help us make the calculations. I am sure it wll be of great help to all members here. Thanks.

Well whatever is not worth buying maybe worth writing 🙂

Btw, did you check this chapter on Normal Distribution? – http://zerodha.com/varsity/chapter/volatility-normal-distribution/

Gives a perspective on option writing.

Sir, You must have explained but I want to know again that how to put target and stop loss on a naked call or put option. We know only spot price movement and its probable range. Shall the target and Sl be define on spot price or option’s premium?

Thanks

Its best of the SL is based on the spot price.

Hi bro,

I think I have started to get a “feel” about what options are all about. Feels good knowing these stuff. Thank god I found out about Zerodha & Varsity 🙂

I have few queries about volatility and as I understand its like:

1) I know if there are any events then volatility shoots up.

2) I know if there is nothing special(no events) its going to stay at reference level (i.e. like you said VIX of 18).

3) Question: when exactly does VIX go down? why does volatility go down? I have few guesses like dull market due to holidays etc but I need your expert answer 🙂

Thanks Karthik bro!

Hari,

1) Before any important event, Volatility increases

2) Events are not the only thing that drives volatility…increased trading activity can also drive the volatility.

3) Typically VIX goes down when fear goes down i.e the market should go up.

when volatility increase option premium also increase ..so in case of nifty volatility means implied volatility or India vix,…?

when vix going down and iv of call option increase which means there is a chance of increasing option premium… Right?

and last qusition in option greek calculator which iv we enter the volatility box call option or put option’s IV

For Nifty you can take Vix as reference for IV. So when IV goes down, then probably its more favorable to buy options provided you also have a directional view.

IV is invariable same for both CE & PE.

what about usd inr , what is the volatility that for bs calcs?

Historical volatility can be used here.

Hello karthik ji

wonderful article, i have a question that is from todays data, arvind ltd highest OI at 330 today on call side, but as per chart it indicate that price has given a breakout and it can go back further, hows interpret it than

Seems like the market is bullish on the stock!

Hey Karthik,

Thanks for the wonderful article.

Since you have divided the time in 15 days interval but what about when we want to buy expiry which is two months away. Will the same charts/conclusions work ?

Yeah, 2 months away is still as good as ‘start of the series’ so you could stick to those guidelines.

Could you hint, how Hedging can be done with the help of Options?

Is it good enough to say BUY Put Options of NIFTY for hedging – but how to determine how many contracts and what should the strike price?

Assume you have 2 lots of Future long, the delta equivalent for these two lots would be +2. To hedge this position you will need to buy puts which add up to -2. This would mean you buy 4 ATM puts.

Thanks. Should we square-off the position at any change in the moneyness or just let it expire on the day eventually?

Well, you square off when you are profitable 🙂

Taking Theta into consideration, If I sell MIS option and would like to collect premium then would it be better to sell ATM or OTM?

OTM. Also, to capture the effect of Theta, you need to holding the sold option position over multiple days.

Thank You

Welcome!

Hi Karthik,

please confirm,

1.) Nifty Underlying is 8629.15. If i were to take CE call buy at strike 8500, at a premium of 139.50. So at close of expiry i.e. 25-Aug, The underlying should be above 8639.50 to consider a profit. Say on end of expiry the underlying was 8650, then is it 10.50 * no. of lot, considered the profit?

2.) if i were to write a sell call option for 8800 strike at prem 5.30 and say at expiry the spot is at 8650, then i get to keep the premium of 5.30 or if multiple lots have been bought then it is 5.30*no. of lots. Is that right

Thanks in advance.

1) Nifty should be 8500 + 140 = 8640 for you to breakeven…and you make a profit over and above that. Yes, it would be 10.5*lot size.

2) Yes you will retain the premium as long as Nifty is at or below 8800.

Hi

I am struggling big time on premium profits When selling options. I completely understand above situation where full premium will be capped if the spot Prise stays above strike sold. BUT what I don’t understand is the wild movement of premium during days where Zerodha position shows losses! (Even if spot is above strike)

E.g. – Sold Banknifty 26000PE at 115 on Friday 3:20pm (Banknifty spot 26500),

– premium on Monday morning ( before Market open) was 104

– Monday market opened 300 points down, and premium was 209… Crazy!! So instead of earning time value I ended up in loss?

Can you not only help what went wrong in this situation? And how can I learn premium movements overall from start of week to expiry + volatility shocks?

Pl help! Guide!

Dilip, at any given point there are multiple forces simultaneously influencing the option premium. While there was a time decay (theta), the fall in price (delta) had a greater impact on the option premium.

One of the better ways to retain premium is by selling out of the money options, holding to expiry, and pocketing the premium.

Thanks for the above clarification, Sir say if I want to opt for any one of the above option for current expiry, can I do that even on last day of expiry i.e. 25-aug. & is 3:30 pm the cut off.

On expiry day the current month contract expires…and therefore you cannot transact in that contract. However, you can buy/sell other contracts.

Hi Karthik,

Pls tell what you mean by we cannot transact on the contract on expiry day. Can we not sell when premium goes up?

On expiry day, the contract ceases to exist. However you can transact till it expires.

Excellent site to gain knowledge .Kudos to Zerodha team.

I’d like you to validate my observation which is on Day 1 of Sep month series the Nifty spot closed at 8572 ,sep futures at 8628 and sep 8500CE at 8702 (delta would be at 0.85).Was it a good idea to buy futures and short 8500CE ? this way we could pocket premium of 8702-8628=74 points as 8500CE and futures both will converge to end at same level?

When will this strategy fail ?

Happy to know that Kamal!

September 8500 CE cannot be at 8702, I guess you are missing something, was it 87.02?

Sorry Karthik, It’s 202 and not 8702 ..

Guessed as much 🙂

Hi Karthik

Thanks a lot for the detailed explanation; If I want to judge whether Implied volatility is moving high or low for an individual stock (in order to take a decision whether to short or long an option), how can I get the data of historical Implied Volatility ; I understand we can easily calculate historical volatility, but how to know historical IV movement ? I tried the below link, but it does not capture Implied Volatility.

https://www.nseindia.com/products/content/derivatives/equities/historical_fo.htm

This one is a bit tricky. The dirty way to do this is by comparing today’s IV with the historical volatility and make an assessment.

Thank you Karthik

Welcome!

Hi Karthik, I am new here. I know of options spreads/vol trading, but I haven’t really taken the plunge and done any real trading on a personal account. What’s the best way to get started?

The best way would be to run the strategy would be to actually deploy it in real markets and start taking small bets 🙂

Hi Karthik,

How to know beforehand that volatility of a particular option is going to increase ?

Is there any particular mechanism to predict this

or

should we just keep watching the option chain of the underlying to see if its volatility is increasing?

You can forecast volatility by employing volatility forecasting models like GARCH. This is a quant heavy topic and requires you to have some background in stats.

Is there a chapter what specifically explains at which strike price an option should be bought at ?

This chapter itself helps you identify the strikes 🙂

Call option of Asian paints of strike price 960 is at 1.25₹, if tomorrow Asian paints again fall much so then will this call option turns to be zero value? And if day after tomorrow Asian paints goes up then will my call option continues to rise or my contract will be end as soon as the call option value turned zero?

Yes, thats how a call option functions. However, the option price will not go to zero as it has time value.

There’s a table in the end of this module, which highlights the “Best strike to trade” based on target expectation timeline and position initiation timeline. Is it applicable for all 4: Long call, short call, long put, short put.

Yes, it does.

There’s a table in the end of this module, which highlights the “Best strike to trade” based on target expectation timeline and position initiation timeline. HOW DOES THIS HELPS IN STRIKE SELECTION IN SELLING CALL/PUT. Pls suggest

Best strikes to trade – by trade I mean to say both buy and sell.

Dear Karthik,

Greetings. In Chapter 22, monthly series is divided in to 2 halves and results of the trading is explained with the help of 8+8 bar charts. Is Volatility Cone is the basis for these bar charts ? or any other thing. Request your clarification on this.

Regards

No, these charts are developed using R, basically an algorithm which suggests which is the best strike to trade for a given timeframe.

Thnks for reply

Cheers!

Dear Karthik,

When back calculating IV, taking nse option prices, using BS Model and Binomial Model, IV values are differing significantly. Binomial Model, resulting lesser IV. Any explanation? Which Model is correct wrt profitability ?

Regards

I know both binominal and B&S models lead to similar premium values. However, I’ve never tested for historical IV’s. So I guess I wont be able to comment to this.

While trading options is it important to look just at the volume figures for liquidity purpose or should we look into the Open interest figures as well? If yes for both, then could you tell how much is the ideal level for a contract to be liquid (volume and OI separately)? Also, I see that some call option contracts rise tremendously in value even if the underlying has fallen in value..for example on 24 march, TV18BRDCST CE of 27th apr 17 expiry, and strike of 52.5 rose by 3300% from the previous day close.. this has happened even if the underlying fell by 0.57% from previous close. Is there any way to spot such contracts and cash the gains by selling the contract soon ? 🙂

While both are important, I particularly look at volumes. Always compare today’s volume with respect to average volumes for a particular timeframe. For example, I’d look at today’s volume with respect to last 10 day average.Ditto for OI. Its hard to spot such trades, but with good amount of skill and luck, you certainly can 🙂

When I see the open interest and volume data for equity options, most of the times the open interest is extremely high when compared to volume throughout the trading month. So since volume is the number of contracts traded and open interest is the number of positions that are still open, if say for example I see the NIFTY 8000 call of 25 jan 17 expiry, till the expiry date the volume was around 8403 and open interest was 95925.

1) Does this mean that after market close 87522 contracts (95925-8403) were exercised?. This seems to be the same case where most of the options are exercised for other underlyings as well. Note that this is an ITM option.

2) Doesn this indirectly mean that a lot of people are ending up losing money because there is a greater STT that is levied on exercising options? And why are people exercising instead of squaring off?

3) what will happen if I try to square off an ITM option on the day of expiry but I don’t find any buyer for my option?

1) Not exercised, but closed. Remember exercise happens only on expiry day

2) No – hard to judge the profitability based on the movement on OI/volume data

3) If there is no counter party, then you cannot square off. But upon expiry, the exchange will settle it on your behalf, although you will end up paying a huge STT for ITM option. Check this – http://zerodha.com/z-connect/queries/stock-and-fo-queries/stt-options-nse-bse-mcx-sx

Hello karthik sir,

I have a question i am tracking May, 2017 currency option(USDINR) for sometime

today(21 april) underlying in red but ATM and slightly Atm & OTM puts mean close to underlying price also declining not much but little bit why this happining as per my calculation volatility is normal not decreasing , and there is lot more time to expiry then no problem with theta

Then why this happening

I guess this is due to all options contains excess value to protect Seller s and as this option going to be current months the price reaching towards normal or fair range

Am i right sir pls…..correct me if neccsesory….

Maybe due to liquidity issues. Keep track of the traded prices, sometimes when liquidity is low, the option premiums misbehaves 🙂

SInce STT on exercised options is quite high and eat up profits made in ITM options, then how can traders square off contracts whose daily volume are also low? for example if you look for SBI CE strike 275 with expiry 27 apr 2017, from 27 mar till 27 april in the following link https://nseindia.com/products/content/derivatives/equities/historical_fo.htm the daily contracts traded for this option of SBI till the day of expiry is quite low. In this case will you suggest that the trader buys only one or two contracts so that he can sell it easily before expiry and he can avoid the trap of any options not getting squared off due to insufficient buyers? Second question is, you can see in the data that the open interest figures are quite high even till the date of expiry. so does this mean that lacs of contracts got exercised on their own on expiry day and the option holders ended up paying the high stt?

Yes, in fact ample liquidity is one of the key criteria for selecting stocks for intraday purpose. Its tough to find liquidity beyond 4-5 big names (ICIC, RIL, Infy TCS etc). Yes, many contracts gets exercised upon expiry. For people who dont know, they end up paying high STT.

How can I find liquid stock option contracts (with specific strikes) and be sure that I will be able to find a buyer easily if I want to sell my contract before expiry? Also, if a contract for a specific strike has had over 1000 daily volume in past month then does it indicate that in the future months also it is more likely to have good volume? in general how do I know that a particular strike of a stock option is going to attract good volumes?

You just need to scan the market to figure out where the liquidity lies. Usually, it is concentrated in few names such as – Nifty, Bank Nifty, ICICI, Infy, SBI, HDFC, RIL, TCS etc.

No, today’s volume does not guarantee future volume.

How do you arrive at the 8 graphs in section 22.3 of module 5-2. These are used in module 6 also. Are these based on historical data and remain unchanged or one has to plot them for every strategy. Plz ignore if the question is too dumb.

These are used extensively through out the module. They are created busing a software called, R. It essentially captures the general behavior in which the option strikes behave wrt to time to expiry.

Thankyou Karthik ☺

Cheers!

Can you please guide me how to trade in option from Zerodha pi/kite.

Start with this very module, Uday 🙂

Dear Sir,

Option chain contains current month, Mid month & Far month. For example My doubt is if current month not available volume, open interest or Bis ask spread is more so I wouldn’t take any option position. Then I drill it down find a mid month or far month options satisfied with Volume, Bid and ask spread. So if I want to select the option (ITM, ATM & OTM) how to consider or think 1st half of the series or the 2nd half of the series to initiate the trade.

In the present Indian context, you will not find this situation. Liquidity is available in the current month as opposed to mid or far month.

Dear Sir,

Do you have modules on option strategies??

https://zerodha.com/varsity/module/option-strategies/

Hello Karthik,

The above charts really get to the core of why successfully trading options remains a challenge to many retail investors as myself. That said, a chart of Theta vs Strike Price will also help in understanding the core concept, IMO. I ended up searching for the chart when I realized that time value of ITM options is less than that of ATM options, which I found quite confusing.

I’d read on the internet that Deep ITM naked options are a relatively safe bet but the above charts along with Theta-vs-Strike-price is really driving the point home for me.

Thank you once again for this excellent material.

Happy learning, Rahul 🙂

Why is 5th module not available for download??

NExt week.

Guruji,

Excellent stuff. If possible, please post table of Position Initiation Target Expectation Best Strike To Trade for banknifty weekly options.

Is it a correct strategy to buying two strike price Call / Put when banknifty did not have trend of more than 200 points and forecasting it would rise / fall ? Please do let me your views. Is there any formulae to predict the premium based on predicted index if I know all the geeks and implied volatility. Thanks and Regards, Arijit

Ah yes, that table has been pending for a while now 🙂

Any strategy requires backtesting, Arijit. Cannot make a blind statement 🙂

Guruji,

Thanks for your prompt reply and the suggestion for backtesting. Will confirm my theory with sample from 01/01/17 should suffice.

Do you know or where can I find Black Scholes formular to predict the premium based on predicted index if I know all the geeks and implied volatility?

Thanks and Regards,

Arijit

I’d suggest you take more data points, at least for the last 2 years. Check this – https://zerodha.com/tools/black-scholes/

Guruji,

Thanks for the sample size …works in progress…

I require formula not calculator as I know how to calculate the geeks from options chains table but I want to calculate the future premium for a strike price for predicted future index and current geeks…

Thanks and Regards,

Arijit

Ah, expected premium? This has to be again based on how the expected change in greeks, not sure if something of this sort is available online.

Guruji,

I want to write the calculator based on the formula calculating the premium for a strike price for a range of forecast index price, based on calculated geeks from option chain table.

Please help, if possible.

Thanks and Regards,

Arijit

I’m not sure about this, Arijit. Can you elaborate a bit more? Thanks.

You are a True Teacher!.. Who Knows what the students expect …

We wanted this kind of Summary and reinforcement of complex Options in one single chapter!

Happy learning, Ravi!

Hi Karthik,

Great learning from you. I just wanted to know how will you choose strikes in case I want to short options. This is because I have a portfolio and would like to hedge it and collect premiums. Do we still select strikes in the same manner as we do while buying options? Also, is it a good idea to short both call and put options to hedge each other out?

Regards,

Gaurav.

What standard checklist, pattern and indicators do you strongly use on a daily basis for intra day or 2-3 days type of trades while trading the “Nifty 50 Index Option”?

Whatever I’ve mentioned in this chapter. I avoid buying options close to expiries and buying when volatility is high.

Dear sir,

This chapter is highly confusing!

If your target is achieved in 5 days do u square off at that point or continue till expiry? You target at the profit in premium or profit at the end in the strike price?

If the target is achieved, then you got to get out the trade. Why wait till expiry?

Hey! Since volatility increases when an important announcement is coming up, and increase in volatility is directly proportional to increase in premium, so irrespective of the result of the company, it would always make sense to buy a call option around 1-3 days before? If true, then what would be the appropriate strike price for this?

Volatility tends to increase, does not always increase! However, if it does, I would be comfortable buying slightly OTM, assuming there is at least 5- 8 trading sessions before expiry.

Dear Sir,

If we know the target is expected on expiry day, it is suggested to buy ITM strike option during the first half of series.

1. which ITM strike option to buy? Slightly ITM or ITM?

2. If we buy ITM option and there is no price movement in the underlying, would the premium erode due to Theta value and lose money? what happens to premium in this case?

1) Slightly ITM or ATM

2) Yes, premium would erode.

Guruji,

Your pedagogy is excellent and reflects what you have gone through to arrive at level of excellence !

————————————————————————————————————————————————

You get compute geeks from option table.

There should be formula with which one calculate the premium (by Black Scholes) for forecast index.

Hope the above is clear.

Thanks and Regards,

Arijit

Ah, I get it. This may not very intuitive since both the premium and the index movement (delta) are co-dependent. So you will end up in some sort of a circular loop when trying to do this. Anyway, let me give it more thought. Thanks.

It’s very good. the contents are so elaborative, I am good to read this. I shall apply it to real trades.

Good luck and happy learning, Rajiv!

how it is affecte to P&L ;

1) X share trading at 100(spot price). i know share will be up 20 points(i.e.120) within 25 days. i bought CE option with slightly ITM (first half of expiry). but market react early and target achieved within 5 days. how affected to p&L as well as any other point that should be keep in mind ?

2) which Moneyness for call option i have to choose when i only know X share have upward moves from current level ? May be 1st or 2nd half of the series.

3) what is the thought behind buying/selling of next months expiry ? or better to not jump at initial level.

1) In this case, the options premium will go much higher than the value predicted by delta. This is because of ample time value.

2) If you have sufficient time, then opt for slightly OTM option, else opt for ATM option.

3) Liquidity could be an issue with next month options, I’d suggest you stick to the current month options.

Good luck.

Sirs,

I am Rajan A.T.

After going through this chapter on ” Reintroducing Call & Put option, Kindly clear my following doubts.

a) How is a Call option is different from a Put option for a same strike rate? for example How the ATM of today ( 16-01-2018 ) 10700 CE is different from the 10700 PE ?

b) How ITM shift from left to right after ATM ie the light yellow back ground

If the answer is of long stretch kindly give me a link to this answer.

I have read this module no 5 two times . I could not get the answer for my above question.

Please allow me to give an example of some what same to compare.

Take chart of a Railway Time Table (RTT. in short) . This is a common chart familiar to almost maximum number of people.

Let us compare both charts. The Railway Time Table (RTT. in short) and the Nifty Option Chain (NOC. in short)

1 The central Strike Price column in the Nifty Option Chain (NOC) can be compared to the Train No and train name column of the Railway Time Table (RTT).

2. The left side of the strike price column in NOC is Call option and its details . same way

left side of RTT is UP direction of the trains and details of stations on the route and arrival & departure time of those stations.

3 The right side of the strike price column in NOC is Put option and its details . same way right

side of RTT is DOWN direction of the trains and details of stations on the route and arrival & departure time of those station.

Kindly compare like this and make it very simple to understand.

Considering the effort & time the full team of people have invested to prepare such a beautiful and versatile book, these type of comparison charts will go a long way. SORRY for taking your valuable time.

Regards

Rajan A. T.

1) The basic difference is in terms of the directional opinion – you make money on call when the stock price goes up and you make money on a PUT when the stock price goes down

2) This depends on the option type (calls and Puts). I’d suggest you read the chapter on Moneyness of option to understand this better.

The RTT example is nice, unfortunately, I’ve not traveled much, hence not too familiar with the railway chart. But appreciate your inputs. Thanks.

margin money is like a loan or a debt. isn’t it? so am i liable to pay the extra money that i borrowed as margin money for intraday trade that enhanced my profit??

Sort of yes, but this is a standard feature offered by most brokers and no one really charges for it.

i am actually new to trading and when i received a mail from NSE at the day’s end of stocks bought and sold and it showed that i actually traded in lakhs when i just had 5000 in my account, that really got me scared.

Yes, that would be the total value of the transaction. Thanks to leverage 🙂

The way you bifurcated one month option contract into 15 day i.e. the effect of time on premium .

Can you tell me the effect of time in premium in case on Bank nifty as the option contract are for one week (as per my knowledge. I am new to all this stuff correct me if I am wrong).

That would be too short-term a trade to classify options. I’d suggest you stick to ATM for all trade types.

Dear Sir, Please refer the last sentence in 22.3 ” the best practice for buying options differs with last column of the table where as it mentioned for trade

Is it same for buying and selling the options.

I.e 1st half of the series and the result is expected in 5 days from the initiation, the best strike to trade is far OTM is it holds good for both buying and selling.

Regards

The table stands good only for buying Call and Put options and not for short-selling(writing) an option contract

Thanks for your clarification. So what are the best possible strikes for writing.

Hi Karthik,

As usual excellent explanations. I have a question about how one decides whether a target is reached within 5,15 or 25 days. I know that we can set our targets using Support and Resistance lines but how to arrive at the timeline for such a trade?

Thanks in advance!

Hmm, this will be a tough call and not an easy one to predict. You can only make a generic guess on the timeline involved in achieving the target, but no logic based conclusions.

How does one predict that the volatility will go up or down?

Models such as GARCH(1,1) helps in predicting the volatility.

I tried many sources but learning GARCH (1,1) model seems tricky. Could you share any simplied source?

It is indeed a complex topic, Rinkesh. Let me look through few sites/articles.

Lets keep aside any mathematical model and I want to try and understand the rationale behind the volatility. For example: Lets consider recent PNB case. The volatility has decreased in the last two trading session. But, news can come up at anytime. So, discard the directions, can this be considered an opportunity to buy options (call or put)?

Hmm, I don’t think the volatility has really reduced. To assess this, you need to look at the current vol and compare it to the historical vol. Anyway, on another note, I’d be wary of buying options so close to expiry.

I think I need to develop a mindset and understand various cause-effect relationship. However, I would urge you to describe any other mechanism which can help us forecast volatility as I couldn’t find GARCH (1,1) volatility.

Also, the greek calculator at Zerodha gives output of call and put option premium. So, according to the calculations that should be the ideal premium one should pay? I didn’t understand it.

Garch (1,1) is a quant heavy topic, Rinkesh. Let me see if I can break this down into smaller bits and put this across. I’ll need time for this. Yes, B&S calculator gives you a fair price also called the theoretical price.

Okay, I have come across the charts of IndusInd bank on daily time frame.

1) Bearish Marubuzo

2) Increase in Volumes

3) Key Support level (now resistance) 1600 was breached, so conciding with 4% stoploss as the high of the candle was 1634.

Now, hypothetically I want to go short on this via put options. Please explain me how to set up. I have understood that strike price should be selected according to the trade initiation and expected time period to achieve the target but still I am not able to predict whether the volatility would increase or decrease. (Let me try and put up questions in consequence and clarity.)

Q1) I have thought to short IndusInd Bank based on technical analysis and getting to know about current NPA situations across the banking sector. So is this mind set logical?

Q2) Lets say, I choose the March, 2018 expiry and there is plenty of time left. The target of Rs 1530 at spot market is expected to be achieved in 5-7 days. Therefore, I would choose far OTM (may be 2-3 strikes away from ATM.) ATM=1600 so I would want to go with PE option at Strike Rs 1560. We should use historical volatility to place a stop loss. I just guesstimated the time period for target. (Please let me know how you would have estimated the time period) *Am I correct with choosing strike price?*

Q3) The Implied volitility is 27.74% for the strike I have chosen. Now, how to forecast whether the volatility would increase or not? Keep aside the statistical model and tell me how do you sense the general perception of volatility keeping our example in mind. [Well, I have also asked for GARCH (1,1) model too.]

Q4) I used the Zerodha calculator of Black & Scholes Option Pricing Formula and got Put option (1560 Rs) premium to be Rs 27 and while checking the option chain on NSE website, the premium for the same strike was Rs 31.80. How do you infer this difference? Should we place order at Rs 27?

[Imp Question] Q5) I saw VIX index and there was a fall in volatility. So, how to take that into consideration?

I know I seem to be too confused and I have read the chapters twice but still I am quiet stuck with volatility part. If you could answer my questions in consequence, that would be great. Thank a ton 🙂

1) Yes, because you have developed a point of view here

2) If you expect the move to happen over 5-7 days then going for 1560 makes sense. However, timing the market is hard, hence I find saftey in ATM options. Yes, you can use historical vol to place SL

3) If you expect the stock to fall, then vol will increase

4) Yes, as 27 seems to be the fair price.

5) ViX is best approximation for the Index not for individual stocks

Good luck!

Amazing. I got the gist of it. Basically, during the consolidation phase, the volatility drops and when you expect a move in either direction, the volatility tends to increase? So if we are expecting a move then we should Long options.

But it would be opposite when there is a key announcement or news in near future. Till that time the volatility would increase because of uncertainty and the the dust gets settled down leading to drop in volatility?

Isn’t both of the above things contradictory?

Yes, that is true. With respect to the contradiction you are referring to – thumb rule is – high vol (and you expect it to go down), look for selling options, low vol (and you expect it to increase) then look at buying options.

Guruji,

Excellent stuff. If possible, please post table of Position Initiation Target Expectation Best Strike To Trade for banknifty weekly options.

Have you heard of Ed Raman Support and Resistance …sorry for posting this query…

If yes, please let me know.

Thanks and Regards,

Arijit

Will check on the Bank Nifty weekly contracts, Arjijit.

No, I’ve not heard of Ed Raman’s S&R. Let us know if there is any interesting information on that. Eager to learn.

Guruji,

It is available as a tool in Optuma but no details given how it is calculated by them nor in the Net.

Observation about weekly bank nifty charts shared for information.

Weekly swing of bank nifty is about 3% viz. 750 to 800 points

Short Strangle on next week bank nifty , at strike prices higher/lower than swing band at thursday.friday, gives return between 2 to 3 % , when volatility is high.

Thanks and Regards,

Arijit

Thanks for sharing your observations. That seems very possible, Arijit. But you need to ensure you are aware of the monetary policy announcement. Bank Nifty can swing wildly around these days. Good luck and stay profitable 🙂

Guruji,

The observation is due to back trsting as suggested by you. This was weekly credit strategy when volatility is high.

Dfferent strategy at play (buying call / put) near and at expiry on bank nifty derived after combination of various theories viz.Price action, Square of 9, Elliot waves and Ichimoku which gives stop loss, entry and exit levels of indicies plus moving averages and MACD on 5 / 15 minute chart with robust risk management and strict discipline in place. Just shared my thoughts with you.

Thanks and Regards,

Arijit

Great! Hope success (and profit) rolls your way 🙂

Hi Karthik, Could you please share the excel sheet to generate the P&L graphs at various strike prices as illustrated? Thank you in advance.

Hmm, I afraid I’ve lost these excels. However, you can take a look the Excel sheets in this module (all chapters have one) – https://zerodha.com/varsity/module/option-strategies/ and use them. It kind of covers whats being discussed here.

Is there any calculator/model/method etc. which can help me know about the possible future price of an option contract if I have the current stock price (underlyings value), days to expiry, volatility information, expected future price of the stock?

You can try variants of the B&S calculator for this. By the way, if the expected future price of the stock (on the day of expiry) is known, then the option price will be equivalent to the intrinsic value.

is it better for a beginner in options trading to trade usdinr options since the capital required for buying options is very less compared to equity/index options and usdinr options have good liquidity as well? What are the things that one should be careful about so that there is no unseen trap (like the STT trap which previously equity options traders faced) when I start to trade in usdinr options?

Hi

Suppose in first half of series I buy deep OTM CE option with target expectations of 5 days. But instead of 5 days my strike is achieved in 15 days . Why would I lose money then?

I am not able to understand that. Afterall I have achieved my OTM target before expiry .

PS: I don’t know it’s relevant questions or not . I hope I am putting it in right way

You may not lose money, but you may make lesser profits.

Sir,

I bought put call of TCS i,e TCS 18MAY3200PE and strike price was 3400 (I think this may be far away from ATM) on dt: 23.04.2018 and noticed that price is moving down ( 25 points fall on the next day) as I expected i.e in my favor. But premium found loosing from 30 to 27.80 i.e 2.20 point down which in term showing loss of Rs 550/- instead of gaining something, i hope, requested you kindly let me know logic behind it please.

Pradeep, this is because the volatility had shot up (remember TCS results were due) and as volatility cooled off, the options reacted. Suggest you read the section on Vega in this module.

Dear Sir,

Can we use the same methodology of strike selection (Nifty -monthly contract) for bank nifty weekly contract also? by considering 1st 15 days as first 3 days.

Thanks.

Regards

S.Lawrence

Yes, you can extend this to Bank Nifty as well.

Wow, what a great explanation…. Thank you so much Karthik

Welcome!

Hi Karthik,

Nice information on varsity. Really useful for beginners like me. Consider bank nifty expiry week starts on friday and expires on thursday.

1) What should be the difference (spread ) in call ratio back spread to incurr minimum losses.

2) when we should take position for bank nifty in call ratio back spread ? At the expiry of current week for next week ? Or on Friday morning at the time of opening of banknifty expiry week ?

1) I’d suggest you stick to the classic spread 2:1

2) Ideally, this depends on the situation but yeah, I’d prefer Friday.

Hi Karthik..its great to write to you again after a long time..my question is regarding strike price selection

say for eg.. banknifty spot is at 26000..i have identified 26000 as a support zone doing some analysis.. and i think that price is going to go up soon..also, in the 30mins chart the previous swing high is at 26900. so 26900 is the resistance, hence for this i would buy calls with strike of say 26700..my idea behind this strike price selection is since 26700 call is now OTM, as the price starts to move from 26000 upwards 26700CE will soon rise in value and may even become ITM (considering I have enough time for expiry)..however, i did not make use of any greeks here..my entire strike selection was based on guessing levels which price is likely to penetrate by using technical analysis..what do you think of such a way to select strikes?

Frankly, there is nothing wrong here, it is just that being aware of Greeks helps you calibrate your trades better. However, here is a suggestion – when selecting strikes based on any non-greek based approach, I’d suggest you stick to ITM options.

Hi Karthik,

Here’s my understanding of the first example you gave.

The 5500CE purchased in the first half of the month is most profitable if the target is achieved within 5 days. However, this is a deep OTM Option. Hence the delta would be non-zero (if there is high volatility), but substantially lower than that of the OTM option (linear Delta curve). But, the deep OTM 5500 trades at lower prices than OTM (5300). Even though absolute change is higher for OTM (higher delta), % change for Deep OTM surpasses that of OTM.

Based on the above reasoning, the higher gain for deep OTM is only attributable to the high volatility of the stock, as without it, the delta value would be zero for deep OTM, and there would be no Vega effect on Premium either.

Is this conclusion valid?

I’d agree with you on this. You need also need to pay attention to the fact that the target is achieved within 5 days of trade taken (especially in the backdrop of more time to expiry). The speed of the market is also very crucial here.

Yes, and the speed of the change is the reason for the high volatility right- %change per day would be high over those 5 days?

Hmmm, the speed of change usually refers back to the directional movement of the stock. A stock can be volatile, but essentially stay put in the same price range.

Hi Karthik,

Tell me if this strategy will work-

1. Next day Expiry-

Today say Bank Nifty or any underlying closes at 26000 and tomorrow is the expiry. I see 25500’s Greeks on Zerodha BS calculator and it shows premium as 104.5

I predict that on expiry BNF will stay above 25500 and will be in the money at expiry.

25500 opens at 107,

a. That means people are paying ₹3 more over and above the fair premium right?

b. Given the price stays over 25500 till say 2PM, isn’t it obvious that the premium will be over 104.5 which the Greek calculator has said Yesterday given it’s expiring ITM?

1) Yes, and this is also a function of market’s demand and supply.

2) Technically, the premium will be very close to the intrinsic value (considering its expiry day). So the 25500 CE strike will be trading at 500 given the spot is at 26000.

1. For point 2- you mean the 104.5 premium which the calculator gave applies only when the spot is 26,000 at expiry because while giving input to the calculator, I used spot 26,000.

2. Now if I think spot will be 25750, I should input spot as 25750, strike as 25500, expiring tomorrow (Thursday) and then the premium comes to say 99.8.

Today on Wednesday premium is say 110, but the calculator using my predictive close of 25750 said 99.8 for Thursday, then it’s not a good deal for me given I’m assuming my prediction will go right.

3. Basically, I’m trying to get better at price prediction of underlying and not focus on premiums only cos if my prediction is right w.r.t. the underlying and I enter below black scholes Intrinsic premium, then I will definitely earn, right?

1) No, the calculator takes in all the variables you’d feed in a throw out an answer

2) Input the details as in. Read this for more details – https://zerodha.com/z-connect/queries/stock-and-fo-queries/option-greeks/how-to-use-the-option-calculator

Hi Karthik,

Thanks for being such an amazing person.

I have started trading options very recently with 10k capital in hand and with that limited money, I have been able to trade in NIFTY and Bank Nifty only.

I trade solely based on EMA, RSI and MACD. The help I want from you is suggest me either equity scrips or indices which I can trade using 10k capital and which are not highly operator driven.

God bless you!

Gerry, I’d suggest you stick to the indices. It’s the best when you are starting off.

Hello there,

I am not getting what “2-3 strikes away” means, though I know what striking price is. Can you please help?

It is with reference to the ATM strike. So 2 strikes away mean ATM + 2 strike.

Which strike should I select for intraday option writing ?? Is there any thumb rule in terms of delta and theta ??

Stick to ATM if its intraday.

Hi Karthik,

Thanks for such a valuable lesson.

I have a doubt – You have shown how to choose strike for call/put options if we want to buy them either at the start of the series or at the second half. However, what if we want to write them. Does the same strike will be applicable for writing also given that all the scenarios are the same?

Ex- In scenario 1, you suggested that to buy OTM which is 2-3 strikes away from ATM options, so the same OTM can be selected to write if I think that the underlying would go down by 4% in next 5 days?

Thanks,

Gaurav

For writing options, I’d suggest you take the normal distribution method. Basically, identify the range and associated probability and take a call on which option to write. I think this is a fairly decent approach to write option.

Thanks Karthik,

So basically, these scenarios are good to go when they are combined with price action strategies or breakouts right?

For writing we can follow normal distribution technique.

Yup, this is what I believe is the right approach to write options.

Your hard work should really be appreciated

Happy learning!

Your efforts making people understanding market are priceless !!!

Thanks, Arun. Happy learning 🙂

Hey karthik

truly appreciate your work. Amazing.

just a quick question – how did you derive the P/L (graphs) considering the strike prices (buying options)? any formulas?

sorry, if i have missed behind.

thanks

The P&L graphs upon expiry is done via excel. The rest via R software.

Karthik,

how can i square off the option before expiry. Also does options have M2M. Can you explain how exchange transfer money between market participants in option trading.

You can square of the position, anytime you wish. No need to wait till expiry. There is no M2M in options.

So you make profit from the change in premiums.. right?

And you do it by selling or buying premium.

Whether the P&L calculation will be same while squaring off before expiry?

Yes, irrespective of a long or a short trade, your P&L is dependent on the change in premium.

Hi Karthik, thanks a lot for the awesome material on Options trading

Is it possible to share the excel file you have used for the calculation of the bar charts (profit loss % vs. strike price)?

Charan, that was the output from an R program, not an excel.

Okay, is it possible to share the logic behind the calculation?

Its explained in the chapter itself.

Sir,

If I have purchased 15 Lots of Nifty and paid Margin for it, what is the best time and Rate to hedge the position via buy a Put Option, I am Long term bullish on the market but want to hedge the position due to political uncertainty.

1. At the money ; 1st day of present series

2. At the money ; within 1st week of series

3. At the Money ; always midday of series

4. In the Money ; 1st day of present series

5. In the Money ; within 1st week of series

6. In the Money ; always midday of series

7. 1 strike Out of the Money ; 1st day

8. 1 strike Out of the Money ; within week

9. 1 strike out of the Money ; midday

Same 9-9 possibilities for near month and far month illiquid options

Thanks

Kindly give answer in detail for my problem and oblige

Darshan

The timing is really dependent on the way you understand the markets. Remember this, the delta of futures is 1. Since you have 15 lots, you are long 15 deltas on futures, hence you need to short 15 delta in the options as well, to ensure you are delta neutral.

If you short an ATM option whose delta is 0.5, then you will have to short at least, 30 lots of Nifty ATM options. The problem, however, is that you will have to continuously tweak you position to ensure you are delta neutral.

Sir,

Thanks for your reply, as per my knowledge and feeling 10th-12th day of series is best Rate for Insurance and one strike out of money is best for delta neutral, if you have any Stretdgy to hedge my position, kindly oblige.

Darshan

Hmm, you need to backtest this or at least paper trade this for few expiries before actually taking the strategy live in the market.

Hi Karthik ,

First of all , thanks for a great article. I just had one question. How did you calculate the profitability diagrams for different strike prices with target hit ? Is it the delta*chg in price – theta for the time to expiry ?

Thanks, Soumya. This was programmed in R, keeping the Black and Scholes model in perspective.

here is what I thought would be the calculation :

profitability for the i-th strike = ( expected premium of the i-th strike once the target hit – premium paid for the i-th strike) * lot size

expected premium of the i-th strike = ( absolute point difference for 4 % move ) * delta of ith strike price + (days to expiry) * theta

theta being negative for call option

Karthik, Can you suggest if the calculation is right ?

Broadly yes, but there are other variables as well. Like the vega and theta. You have to assume one of it is a constant while changing the others to estimate the P&L.

thanks a lot, Karthik.

Hi Karthik,

I have a doubt after reading about greeks. Let’s say i am long on XXX18NOV140PE paying a premium of 5. Let’s say the CMP of XXX is 155. Now since i have taken position at the start of the expiry month, there is still long time for expiry. Assume the volatility was high when i went long, hence the premium didn’t come cheap. Let’s say by the time close to expiry (~30 mins before expiry) the volatility cools off and XXX stock price has indeed fallen below 140, say 133. According to the P&L i should be earning Rs 2.

Would the P&L formula still hold independent of volatility dropping and also since premium would be trading slightly low owing to STT trap.

In short, do we necessarily earn profits if the stock price moves beyond strike price +/- premium (+ when CE and – when PE) when we go long? Or can there be a case we incur loss owing to fall of volatility and STT trap resulting in premium being traded cheaply ?

I know that P&L formula holds good only on expiry. Let’s not assume Rs 2 as a solid number. Just say i should be in a position to earn some positive value

Understood, have posted the reply for your previous query.

Vishal, upon expiry you are entitled to receive the intrensic value of the option. In the example quoted you will receive Rs.7, out of which 5 is the premium paid and 2 is the actual profit.

Yes, the STT has to be factored in. There are times when the option is ITM upon expiry, but the STT is so huge that it does not make sense (close to money options). So STT can eat into your profit.

However, volatility does not impact your P&L post expiry. Remember, Greeks, including Volatility are all factors that affect the premium during the series and not post expiry.

Only taxes are real in life 🙂

Hi Karthik,

Thanks for your reply but i have complicated the question by brining expiry into question. Please reset the query to only below

“Do we necessarily earn profits pre-taxation (by squaring off and NOT excercising it) if the stock price moves below (strike price – premium) on Long Put or stock price has gone above (strike price + premium) on long Call? Or can there be a case we incur loss owing to fall of volatility and STT trap resulting in premium being traded cheaply ?

i.e., Is the premium guaranteed to higher than the price i took the position at after the above scenarios?”

If the spot is above strike + premium for the call and below strike – premium for put, then there is a ‘great’ chance for you to make a profit. I’m using the word ‘great’ simply to convey the fact that volatility/theta/major news can play spoilsport.

Thanks Karthik, that is what i wanted to know. So “NOT necessarily” that i will make profit due to greeks even after spot price moves beyond our target!

Learnt a lot from Varsity. Whole heartedly thanks to your wonderful teaching.

A small suggestion, in the current chapter the section “Effect of time” is quite difficult to remember because brain tends to reason “WHY SO?”, except for theta there is not much reasoning. I know internally it’s because of Black & Scholes formula & difficult to put out in words.

Thanks for the kind words, Vishal. About the effect of time bit, let me see what else I can do 🙂

Normally when India Vix is low (16), then market supposed to favour bulls and if vix increases then it is considered favouring bears.

However, when we spot IV of option to be overvalued by volatility come, then we would short the option.

But this contradicts vix volatility ideology, could you pls shed some light on this?

Please pardon the typos, what I mean is , when IV is undervalued we buy may buy PUT option expecting the premium to go higher if we expect the IV to increase.

But when IV is undervalued this also means that there could be potential bull control in near future, hence how can we confidently buy the PUT option

Yes, hence like I mentioned in my previous comment, do not treat VIX as a directional indicator.

Normally when India Vix is low (16), then market supposed to favour bulls and if vix increases then it is considered favouring bears —-> No Bharath, don’t treat VIX as a directional indicator. VIX only tells you the extent of panic in the market, it does not give you a sense of direction.

Thanks for the clarification

Welcome, Bharath!

Hi Karthik,

Thanks a lot for such intelligent teaching with clarity on Options trading.

1- I am unable to understand from where profit loss % derived at various strike price in

5 days of trade initiation

15 days of trade initiation

25 days of trade initiation

On expiry day

2- what do mean by ‘R’

This was generated using a statistical software called ‘R’. Basically, the entire B&S model was codded into R and these results were derived.

In the last part , a table it appears first part of series and second part of the series, i could not fallow, please explain. In both the cases 5days of initiation, expiry date and the same day reaching target, please somebody explain so i get clear picture. IN a month expiry two series both with 30 days details, I couldn’t fallow.

The table just splits the time to expiry into two halves..the initial 15 days and the later 15 days (closer to expiry). With this in perspective, we further figure out how the option premiums and therefore the P&L behaves. Based on the P&L, we further identify which are the strikes to choose given the P&L scenario.

Sir will the table change for weekly bank nifty options?

Not really, Karthik.

Karthik,

For the impact of time on options profitability, i understood the conclusions you have drawn, but i could not understand the underlying reasons for why the profitability behaves in the particular way, like in first half of series, target is expected to be achieved in 15 days, OTM options tend to lose money. Why?

Thanks,

Akshay

Well, that’s just the way options behave. Understanding options is a completely different ball game, remember it is not a liner instrument like Futures. There are multiple factors at play wrt options, which makes it a bit complex.

I looked at option chains for different scrips and this is what i observed: Value of Theta is highest for ATM options and it decreases for both OTM and ITM options, a graph similar to volatility smile.

Should not the impact of time be equal for all the strikes? Why is it that ATM options are impacted most by time decay?

I need to validate this, Akshay. Intuitively, it appears that the theta should be constant. However, if you think about it, the ATM options are the ones which are the most reactive to greeks.

Karthik,

Keeping everything else constant, for each passing day, Intrinsic value of all options will remain constant and Time value will decrease, Infact ITM and OTM options have more chances of staying where they are and hence their theta decay should be highest. Near ATM options have higher probability of converting from ITM to OTM and vice-versa – so their premium should stay high to compensate for this risk and hence lower Theta decay – But what we observe is the reverse – ATM options have highest Theta decay.

Can you pls throw some light on it..

Thanks,

Akshay

You are right in absolute terms, Akshay. ATMs have higher time decay. However, if you look at it with respect to % change then OTMs have higher time decay.

Respected Karthiksir,

*Whole heartedly thanks for excellent coaching.*

I trade only in futures since one year on basis of my technical analysis in charating platform. I have started reading stuffs on OPTIONS TRADING very recently.

There are my basic questions.

(1) On Dt.1/11/2018 I assume that Nifty is bullish above 10200. So I decided to buy 10400 CE trading at 150. On the very next day if 10400 CE rise upto 200. At this moment can I get profit by doing square off 50*75= Rs.3750/- even if Nifty has not crossed strike of 10400??? Is it cumpolsary to get profit that underlying *MUST cross strike price*??? As per my understanding this Rs.3750/- is the difference of premiums of 15000-11250???

(2) In Same case. If due to bad effects of some external affairs Nifty started falling on next day and 10400 CE also started falling upto 100. At this moment can I book losses of Rs.3750 as we are doing in future trading??

Please clear my very basic doubts.

1) You can sell it whenever you feel like, no need to wait till expiry

2) Yes, you can book losses and exit the position.

Good luck, Sharad.

Many Many thanks for reply.

(1) My question —> Is it compulsory for underlying to cross strike price to get profit ?? In my first example can I get profit even if the underlying Nifty has not crossed strike price i.e.10400???

You are sincerely requested to solve my above mentioned query.

In presence of so many experienced traders in this forum my this kind of very basic questions are unnatural. Please forgive me.

Please make this chapter available in PDF.

Sharad, it is not necessary for the underlying to cross the strike for you to make a profit. The premium can go higher even before it crosses the strike. However, if you want to hold the contract to expire, then the strike has to cross the underlying for you to profit.

Thanks a lot Karthiksir.

Good luck, Sharad!