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Mastering Derivatives: How to bet with options for range-bound underlying

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Derivatives

A look at trading options to take advantage of the time decay factor

Time decay is the worst enemy for long option positions. If you buy an option, especially an out-of-the-money (OTM) strike, you know that the price you paid will be worthless in some time; for the time value of the option becomes zero at expiry. Therefore, time decay is the primary factor that works in favour of short option positions. This week, we discuss trading options to take advantage of the time decay factor when you have a neutral view on an underlying.

Range-bound movement

Futures price moves almost in lockstep with its underlying. So, if the Nifty Index moves up 10 points, it is highly likely that the near-month Nifty futures price will increase by 10 points. This is also true for the downside movement in the underlying. So, futures payoff is symmetrical; you can lose as much points as you can gain if the underlying moves down or up by the same magnitude.

What if you have a view that an underlying is likely to trade in a range? This can occur after an underlying has moved up (down) considerably before slipping into a tight consolidation phase – a period where bulls and bears are fighting to move the stock in their preferred direction. It is difficult to trade futures in such market conditions because of their symmetrical payoffs. Options can be your preferred choice when you have a neutral (range-bound) view on an underlying. Why?

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You can generate gains from options through delta for long positions and through time value for short positions. It is the time value that will work in your favour in range-bound markets. Your gains can be accelerated the sooner you can catch an underlying slipping into a range-bound movement from an uptrend or a downtrend. Why?

Time value of an option consists of time to maturity and implied volatility. Note that the time to maturity must decline with each passing day, pulling down time value. So, the decline in time value is accelerated when implied volatility also declines. And implied volatility typically declines when the underlying moves into a tight consolidation phase. There is, however, a trade-off.

If you short an option farther from expiry, the gains can be higher as the time value of the option will be high. The flip side is that your position is exposed to high risk; for the underlying can reverse and gallop in the opposite direction, leaving your short option position with large losses. If you short an option closer to expiry, time decay is faster, but the absolute time value will be smaller. So, what should you do? The optimal period to initiate a short position could be two weeks before expiry for near-month equity options. You could consider next week expiry for options on the Nifty Index.

Optional reading

You should be mindful of the risks associated with shorting calls and puts. That said, you should choose a strike that is currently OTM to moderate the risk of the option becoming in-the-money. As the objective is to capture time decay, liquidity of the strikes is not of primary concern. You should select the strike that has the highest implied volatility among three OTM strikes immediately after the at-the-money (ATM) strike. This logic works for both calls and puts.

Take note

As the objective is to gain from range-bound movement in the underlying, the choice of shorting a call or a put comes down to which has higher implied volatility as it is an important factor in generating gains

As the objective is to gain from range-bound movement in the underlying, the choice of shorting a call or a put comes down to which has higher implied volatility as it is an important factor in generating gains. A caveat: If the underlying shows range-bound movement but the implied volatility is low, you should not set up a short position. This is because you are setting up the position for a quiet movement in the underlying. If the implied volatility is low and then explodes with a quick movement in the underlying, your losses will be large.

The author offers training programmes for individuals to manage their personal investments

Published on May 12, 2022

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