# Professional Trading through Option Theory

## 18.1 - Do it right

These chapters provide a foundational understanding of volatility, standard deviation, normal distribution, and other important concepts. This information will be used for a few trading applications. Two such applications are discussed at this point.

1. How to choose the right strike for shortening/writing
2. Calculating the stoploss in a trade

We will examine the applications in a later stage, however (in a separate module), under a topic called 'Relative Value Arbitrage (Pair Trading), and 'Volatility Arbitrage'. We will focus on futures and trading options for now.

Let's get started.

Option writers face many challenges. They must choose the right strike to write the option and collect the premium. Spot moving against an option writer is a constant concern, but a skilled trader can reduce this.

Normal Distribution allows traders to reduce their worry and boost their confidence when writing options.

Let's take a look at the image 1 for a quick overview.

The bell curve below suggests that the average (or mean) value is -

1. 68% of data is clustered around the mean within the 1 ST SD. This means that 68% of data could be found within the 1 ST SD.
2. 95% of data clustered around the mean within the 2 and SD. This means that 95% of data could be found within the 2 and SD.
3. 99.7% of data clustered around the mean within the 3rd SD. This means that 99.7% of data may be found within the 3 RD SD.

We know well that Nifty’s daily returns will be distributed in an ordinary way, so the above properties can be applied to Nifty. What does this mean for you?

This means that if we know Nifty’s mean and its SD, we can fairly easily make an educated guess about the range in which Nifty will trade during the specified time period. This is an example:

• Date = 11 8th August 2015.
• Nominal number of days before expiry = 16
• Current market price of Nifty = 8462
• Daily Average Return = 0.044%
• Annualized Return = 14.8%
• Daily SD = 0.89%
• Annualized SD = 17.04%

This being said, I'd like to now identify the trading range that Nifty will trade within until expiry (16 days).

16-day SD = Daily SD *SQRT (16).
= 0.89% * SQRT (16).
3.567%
Average 16 days = Daily Avg * 16.
= 0.04% * 16 = 1.65%

These numbers will enable us to calculate Nifty's upper and low-end ranges, within which it is most likely that Nifty will trade in the next sixteen days.

Upper Range = 16 day Average + 16 day SD

= 0.65% + 3.567%

= 4.215% to obtain the maximum range number

= 8462 * (1+4.215%)

8818

Lower Range =
16 Day Average - 16 Day SD

= 0.65% - 3:567%

= 2.920% to get lower range number

= 8462 * (1- 2.920%)

8214

According to the calculation, Nifty will trade in the range of 8214 to 8.8818. We are confident that this calculation will work in our favor with 68% of the time. This means that Nifty has a 32% chance of trading outside the 8214 or 8818 range. All strikes that fall outside of the calculated range are'may' be worthless.

Also,

• All call options above 8818 can be sold and the premiums collected because they are most likely to expire worthless
• All put options below 8214 can be sold and the premiums collected because they are most likely to expire worthless.

You might also want to reconsider buying Put options below 8214 or Call options above 8818. These options are very unlikely to expire in cash, so it is wise to avoid these strikes.

Below is a snapshot of all Nifty call option strikes above 8818 you can choose (short) to write and receive premiums.
(image 2

If I had to choose a strike right now, it would be 8850 or 8900, or possibly both, and I would collect Rs.7.45 or Rs.4.85 premium. These strikes are chosen because I believe there is a reasonable balance between risk (1 SD away), and reward (7.45 to 4.85 per lot).

This thought may be common to many: If I wrote the 8850 Call option and collected Rs.7.45 premium, it doesn't really translate into any significant amount. It is worth Rs.7.45 for a lot.

7.45 * 25 (lot size).

= Rs.186.25

This is where traders often get lost. Many traders think of the gains and losses in terms absolute value, but not in terms return on investment.

You can think about it: the margin amount to enter this trade is approximately Rs.12,000/. Stock market box's Margin Calculator can help you determine the exact margin requirements.

A premium amount of Rs.186.25/on a margin deposit Rs.12,000/- results in a return of 1.55%. This is a good return especially for a 16-day holding period. If you are able to achieve this monthly, it is possible to earn over 18% annually by option writing.

This strategy is what I use to write options.My thoughts about it,take a look.

Put Options I don't like to reduce PUT options because panic spreads quicker than greed. Market panic can cause a rapid fall if there is panic. Even before you realize that the OTM option you wrote can become ATM or ITM, it is possible to lose your money. It is better to avoid regret than regret.

Call Options You can reverse the above point to see why call options are better than put options. In the Nifty example, the 8900 CE must move 438 points in 16 days for it to become ATM or ITM Nifty. This can only happen if there is excessive greed in the market. And, as I mentioned earlier, a 438 move up takes slightly longer than a 438 move down. My preference is to sell only short-term options.

Strike identification It is the complete exercise in identifying the strike (SD calculation and mean calculation, conversion thereof w.r.t. The entire process of strike identification (SD and mean calculation, conversion thereof w.r.t.

Timing - I prefer to close options on Fridays before expiry week. Given that the August 2015 series expiry date is August 27, 2015, I would short the call option on 21 August just before the closing. Why would I do this? This is primarily to ensure that theta works for me. Do you remember the graph of 'time decay' that we discussed in our theta chapter. This graph clearly shows that theta kicks into full force when we get close to expiry.

Premium Collected I write call options close to expiry so the premiums are always low. The premium I collect is approximately Rs.5 to 6. This translates into about 1.0% return. The trade is very comforting to me because (1) Nifty must move 1 SD in 4 days for the trade to be against me. (2) Theta works my favor as the premiums fall much faster during expiry favoring option sellers.

Why bother? Many people may think that premiums are too low so why bother? This was my initial thought. However, I've come to realize that trades with these characteristics make sense to me.

• Visibility on risk and reward should both be quantifiable
• If a trade is profitable today, I should be able replicate it tomorrow
• Consistently finding the right opportunities
• Assessment of the worst-case scenarios

This strategy is a good choice because it meets all the criteria above.

SD consideration I prefer to write options three to four days before expiry. However, if I have to write the option sooner than that then I prefer writing it 2 SD away. Higher SD consideration means higher confidence, but lower premiums. As a rule of thumb, I don't write options if there are more than 15 days before expiry.

Events –I try to avoid writing options when there are significant market events, such as announcements, policy decisions, and monetary policy. Because markets react quickly to events, there is a high chance that they will be wrong. It's better to be safe than be sorry.

Black Swan I am fully aware that markets can turn against me, and I might get caught on the wrong end of the market. It is a huge price to get caught on the wrong side of this trade. You might think that you get 5 to 6 points in premium, but if your trade is unsuccessful you will end up paying 15 to 20 points. All the profits that you have made in 9-10 months are now gone in a month. Satyajit Das, the legendary author of "Traders, Guns, and Money", describes option writing as "eating like a hen, but shitting like a elephant".

To minimize the negative impact of a black Swan event, you must be aware that it could happen anytime after you have written the option. In case you do decide to use this strategy, here's my advice: Always monitor the markets and assess the sentiment. If you feel that things are not going well, exit the trade immediately.

Option writing keeps your edge of the seat. Success Ratio Sometimes you feel like the markets are against you (fear or black swan creeps into), but eventually you will find your balance. These feelings will be common when you are writing options. Worst of all, you might believe the market is against you and thus lose out on a potentially lucrative trade.

There is actually a thin line between a false sign and a true black swan event. This can be overcome by developing conviction in your trades. You will need to find conviction on your own. Your conviction will improve if you make more trades. All trades should be supported by sound reasoning, not blind guesses.

I also get out of the trade if the option switches from OTM to ATM.

Broker to broker, the cost of brokerage fees will vary. Please ensure that your broker does not charge you excessive brokerage fees. Better yet, if your broker is not stock market box, you should join to become a member of our wonderful family .

Capital Allocation The obvious question at this stage is: How much money should I invest in this trade? Are I willing to risk all of my capital, or just a certain percentage? How much could it cost with a%? It's not easy to answer this question so I'll share my asset allocation method.

Equities are my favorite asset class. This means that I will not invest in Fixed Deposits, Gold, or Real Estate. My capital (savings), is 100% invested in equity and equity-based products. It is recommended that individuals diversify their capital among multiple asset classes.

Here's how Equity splits my money.

• 35% of my money goes into equity-based mutual funds via the SIP (systematic investor plan). This amount has been further divided among 4 funds.
• I invest 40% of my capital in an equity fund of approximately 12 stocks. Both mutual funds as well as my equity portfolio are long-term investments (five years or more).
• 25% of the funds are earmarked to support short-term strategies.

Short term strategies can include many trading strategies, such as -

• Swing trades (futures) that are momentum-based
• Option writing

I ensure that I don't expose more than 35% capital to any strategy. Let's say I have Rs.500,000/= capital. Here is how I would divide my money.

• Mutual Funds receive 35% of Rs.500,000/=, i.e. Rs.175,000/=
• 40% of Rs.500,000/=, i.e. Rs.200,000/= goes to equity portfolio
• 25 percent of Rs.500,000/=, i.e. Rs.125,000/= goes to short-term trading
• I would limit trades to 35% of Rs.125,000/=, i.e. Rs.43.750/-
• I won't limit myself to 4 options.
• 43,750/= is approximately 8.75% of the total capital of Rs.500,000/.

This self-imposed rule assures me that I don't expose more than 9% to any short term strategy, including option writing.

Instruments - This strategy is best suited for liquid stocks and indices. This strategy is also used by SBI, Infosys and Reliance. Tata Steel, Tata Motors and TCS are the other options. This is the only list I keep.

Here's what I suggest. The following can be done: Calculate the SD, mean and expiry dates for Nifty, Bank Nifty on the morning of August 21, between 5 to 7 days before expiry. You can find strikes that are less then 1 SD from the market price and write them virtual. To see how the trade performs, you can wait until expiry. If you have the bandwidth, this can be done for all stocks. This should be done for several expirations before capital can be deployed.

As a disclaimer, I must mention that the above thoughts suit my risk-reward temperament which may be very different to yours. These are my personal trading experiences.

These are just a few of the things I recommend. Understand your risk-reward personality and then calibrate your strategy. These tips should help you to develop this orientation.

Although this is contradictory to the chapter, I recommend that you read Nassim Nicholas Taleb’s "Fooled by Randomness". This book will make you rethink all you do in markets and life. It is possible to be completely aware of the things Taleb says in his book and take different actions in markets.

## 18.2 - Volatility-As per the stoploss

This discussion is a digression from Options. In fact, this would have been more appropriate in the futures trading module. However, I believe we are at the right time to discuss this topic.

Before you can initiate any trade, you must first identify the stop-loss price (SL) for that trade. The SL price is a price at which you cannot lose any more. If you buy Nifty futures at 8.300, for example, 8200 may be your stop-loss point. This trade will expose you to 100 points. You lose the trade if Nifty falls below 8200. But the question is: How do you identify the right stop-loss level?

Many traders use a pre-determined percentage stop-loss as a standard. One could set a 2% stop loss on each trade. If you want to buy stock at Rs.500 then your stop-loss price would be Rs.490. You will also risk Rs.10 (2% from Rs.500) for this trade. This approach is flawed because it is rigid. This approach does not take into account the volatility and daily noise of the stock. The stock's nature could mean that it can swing between 2 and 3 percent per day. You could be correct about the direction of trade, but still need to stop the loss. You will regret having such strict stops more often than you think.

Another method that can be used to determine a stop-loss stock price is to estimate its volatility. Volatility is the daily expected fluctuation of the stock price. This approach has the advantage of incorporating the daily noise from the stock. The volatility stop is strategic because it allows us place a stop at a price point that is not expected to fluctuate. A volatility SL allows us to exit logically if the trade does not go our way.

Let's look at an example to show how volatility based SL is implemented.
(image 3)

This chart shows Airtel's bullish harami. People who are familiar with the pattern will immediately recognize that this is an opportunity for them to take long the stock. They should keep the previous day's low (also coinciding as a support) and use stoploss. The immediate resistance would be the target - both S&R points have a blue line. Let's say you anticipate the trade to occur in the next five trading sessions. These are the details of the trade:

• Long @ 395
• Stop-loss @ 385
• Target at 417
• Risk = 395-385 = 10, or approximately 2.5% below the entry price
• Rewards = 417 - 385, or 32, which is about 8.1% more than the entry price
• The reward-to-risk ratio = 32/10 =3.2. This means that for every 1 point of risk, the expected reward will be 3.2 points

From a risk-to-reward perspective, this sounds like a great trade. A short-term trade with a Reward-to Risk Ratio greater than 1.5 is a good trade. Everything hinges on the fact that a stoploss of 385 seems sensible.

Let's do some calculations and look a little deeper to see if this makes sense.

Step 1 - Calculate the daily volatility for Airtel. I did the math, and the daily volatility comes out to 1.8%

Step 2 Convert daily volatility to the volatility for the time period you are interested in. We multiply the daily volatility times the square root of the time to do this. Our example shows that our expected holding period is five days. Therefore, the 5-day volatility is 1.8%*Sqrt(5). This is approximately 4.01%.

Step 3. Add 4.01% (5-day volatility) to the expected entry price to calculate the stop-loss. 395 - (4.1% of 395) = 389. Airtel could swing easily from 395 to 395, as shown in the above calculation. This is within 5 days. Also, this means that a stoploss of 385 could be easily lowered. The SL for this trade must be below 379, let's say 375. This is 20 points lower than the entry price 395.

Step 4 Therefore, I'd be happy to start the trade.

Notice: If our expected holding period for 10 days is met, the 10 day volatility will be 1.6*sqrt (10) and so on.

The daily fluctuations of stock prices are not considered by pre-fixed percentage stops-loss. It is possible that the trader places an excessive stop-loss well below the stock's noise level. This will invariably lead to the target being activated first, and then the stop-loss.

Volatility-based stop-loss accounts for all daily fluctuations in stock prices. We will consider the noise component when we calculate stop-loss using stocks volatility. This would make it more relevant .

### Keypoints

• SD can be used to identify strikes you can write.
• Avoid selling PUT options short
• Strikes 1 SD away provides 68% flexibility. If you require greater flexibility, you can opt for 2SD
• Higher SD means higher range and lower premium.
• Capital can be allocated based on your beliefs in different asset classes. It is always recommended to invest across asset types
• It is always sensible to place SL based upon the stock's daily volatility