Professional Trading through Option Theory

Lesson -> Bringing to a conclusion

23.1 - Journalising

This module is now complete. I hope you have a good understanding of options. This was something I mentioned earlier in the module. I feel compelled again to emphasize the fact that options, unlike futures, is not an easy instrument to understand. Options are multi-dimensional instruments because there are many market forces that interact with it simultaneously. This makes them very complex to understand. Based on options logic logic, I have found that the best way to fully understand options is to trade them regularly.

Let me share with you a few simple trades that were successful. Here's the best part: these trades were executed by Stock Market Box readers in the past 2 months. These trades are based on reading the Stock market box contents, or so I am led to believe.

Either way, I am happy that each trade has a logic supported by a multi-disciplinary approach. It is very satisfying in that sense and makes for a great end to the module on Options Theory.

Please note that the traders were gracious enough to allow me to discuss their trades. However, I will not identify them unless they request.

These are the four trades I'll be discussing.

  1. CEAT India –
    Directional Trade, Inspired by Technical Analysis logic
  2. Nifty - Delta neutral, leveraging Vega's effect
  3. Infosys – Delta neutral, leveraging Vega's effect
  4. Infosys – Directional trade, common-sense fundamental approach

Each trade will have a discussion about what I liked and what I could have done better. All the images shown here were taken by traders, I only specified the format I needed.

So, let's get started.

23.2 - CEAT India 

A 27-year-old 'Options novice' executed the trade. This was apparently his first ever options trade.

This is his logic: CEAT Ltd traded at Rs.1260/share. The stock is clearly in an uptrend. He believed that the rally would end as the rally was ending.

I believe he believed it because he saw the last few candles. It was clear that the trading range for the previous three days was decreasing.

He bought 1220 (OTM), put options to help him turn his thoughts into reality. The premium was Rs.45.75/lot. The trade took place on the 28th September, and expired on the 29th October. The same snapshot is here

To understand the situation better, I asked the trader a few questions.

  1. What made you decide to trade options instead of short futures?
    1. It would be risky to short futures, especially as sharp reversals are possible. MTM would be necessary in these cases.
  2. Why would I trade an OTM option if there is so much time before it expires?
    1. Liquidity is the reason. Stock options aren't liquid so sticking to strikes around ATMs is a good idea.
  3. What about stoploss?
    1. If CEAT makes new highs, the plan is to stop the trade. CEAT making a new high indicates that the uptrend remains intact. Therefore, my contrarian short call was incorrect.
  4. But what about the target?
    1. The stock is currently in a positive up trend so it is advisable to book profits as soon and as possible. Short trades can reverse quickly so it's not a good idea to hold on to them. It would be a good idea to buy a call option and reverse the trade.
  5. How about a holding period?
    1. This trade plays on the appreciation of premium value. This trade will not be held to expiry. There is plenty of time for the premium to appreciate.

Notice - The QnA is reproduced by me in my own words. The idea is to get the gist of the conversation and not to exact word for word.

This is what he did the next day after buying CEAT PE.
(IMAGE 3).

The stock price fell to 1244 and the premium rose to 52/-. He was correct when he stated that "since there is ample opportunity to expiry", a slight dip in stock price would lead to an increase in option premium. He was content with the 7/- profit per lot and decided to close his trade.

This was probably a smart move.
(IMAGE 4).

However, this seems to be a good trade for overnight options trading.

These are my thoughts about this trade. First, I have to acknowledge the trader's clarity and thought. This was his first trade. If I had to create a trade on this, it would have been slightly different.

  1. The chart perspective was clear: exhaustion in rally. This belief led me to prefer selling call options over buying them. Why would I do that? Stock prices can correct if exhaustion is not met. The stock would often move in a sideways direction, making it more attractive to option sellers.
  2. I would choose strikes based upon the normal distribution calculation, as explained in this module. (Needless to mention, one had to keep liquidity in context as well).
  3. To benefit from time decay, I would have made the trade (selling calls), in the 2 and halves of the series.

Naked directional trades are not my preference as they don't give me visibility on the risk and reward. Only when I see a flag formation, will I initiate a naked long call option (based on technical analysis).

  1. Stocks should have rallied prior to the trend at least 5-10%
  2. Correcting low volumes (3% or more) should have been done. This indicates profit booking per week.

This is a great way to purchase call options.

23.3 - Nifty Option - RBI news

This trade is in Nifty Index options, based on RBI's monetary announcement. A stock market box reader in Delhi executed the trade. This trade was well-structured and designed, according to me.

This is the background to this trade.

The Reserve Bank of India (RBI), was expected to announce its monetary policy on the 29 th September. Although it's difficult to predict what type of decision RBI will make, there was a general consensus in the market that the RBI would reduce the repo rates 25 basis points.

Market participants are eagerly anticipating the RBI's monetary policies, which tend to have a significant impact on the direction of the market.

These are some of the empirical market observations that this trader made in the background market events.

  1. Markets do not move in a particular direction, particularly 2 to 3 days before the announcement. This is also true for stocks, ex. quarterly results
  2. The volatility of the event/announcement markets is invariably higher before it.
  3. The volatility goes up and so do the option premiums for CE and PE.

Although I can't vouch for his initial observations, the 2 2nd observation and 3 3rd observation make sense.

He decided to issue options on the 28 of September against the background of RBI's announcement of policy, increased volatility (see below).

The Nifty was around 7780. Therefore, the strike 7800 was the ATM option. The 7800 CE traded at 203, while the 7800 PE traded at 176. He wrote both and received a combined premium amounting to Rs.379/+.

This is an option chain that shows the option prices.
(IMAGe 6).

I had a conversation with him to understand his action plan. I am reproducing it (in my own words) to help you understand.

  1. Why is 7800 CE and 7800PE so expensive?
    1. Due to the fact that there was plenty of time for expiry and increased volatility I believe that options are more expensive than normal and that premiums are much higher than usual. I believe that the volatility will decrease and the premiums will decrease. I would be able to purchase both options back at a lower price.
  2. Why did you choose to use a short ATM option?
    1. It is likely that I would place market order at the exit. This is because I want to minimize the impact cost. ATM options have lower impact costs, so it was an easy choice.
  3. How long do you intend to keep the trade open?
    1. As we get closer to the announcement time, volatility tends to drop. Based on empirical observations, I believe the best time to square these types of trades would be just minutes before the announcement. The announcement is expected by RBI at 11:00 AM on September 29 th. I therefore plan to square the trade by 10:50 am.
  4. What are your expectations for the trade's profits?
    1. This trade will yield around 10 to 15 points in profits.
  5.   For this trade ,what is your stop loss?
    1. The trade is based on volatility so it's best to place SL based only on Volatility, and not on option premiums. This trade also comes with a pre-defined 'time-based stoploss'. Remember that no matter what happens, the goal is to exit minutes before RBI announces the announcement.

He then initiated the trade with these thoughts. To be honest, this trade was more successful than the one on CEAT. Although I can largely attribute the success of CEAT trades to luck, this trade seemed more rational.

However, he was able to close the trade the next day as planned. This happened minutes before the announcement by RBI.

This is the screenshot for the options chain.
(IMAGe 7).

Both options lost some value as expected, and volatility fell. The 7800 CE traded at 191 while the 7800 PE traded at 178. He was able to make a quick profit of 10 points per lot with this trade, as the premium value totalled 369. It was a decent trade for an overnight one, I think.

This is just to give you an idea of what actually happened right after the news broke.



My thoughts about this trade -In general, I believe in volatility movement and shorting options prior to major market events. These trades should be made a few days prior to the event, and not one day.

This is an opportunity to clarify one misconception about news/announcement-based option trades. Most traders I know set up the opposite trade, i.e. buy both Call option and Put option prior to major events. This strategy is known as the "Long Straddle". A long straddle can be described as a simple strategy. After the announcement, the market will move. Depending on market direction, either Call or Put options are likely to make money. This is the simplest way to think of it: hold the option making the most money and then square off the one that is losing. This may sound like an intuitive and logical trade but people often overlook the volatility impact.

The market will move when the news is announced. If the news is positive, Call options will move. But More often than not, the rate at which the premium for the put option will lose value is slower than that at which it would gain . This means that you'll lose more money with the Put option, and make less on the Call option. Selling options prior to an event is more meaningful, because it gives you the opportunity to make more money.

23.4 - The study of Infosys Q2 Results 

The trade is similar to the RBI trade, but it was executed better. Another Delhiite executed the trade.

Infosys was to announce its Q2 results on the 12 th October. It was very simple: news drives volatility up so you should have short options and an expectation that it will be possible to buy it back once volatility has subsided. The trade was well-planned and initiated 4 days before the event on 8 Oct.

Infosys was trading at Rs.1142/- per Share, so he decided that he would go ahead with the 1140 strike.

This is the snap taken at the time that the trade was initiated.
(IMAGE 9).

The implied volatility was 40.26%. On the 8 th October, the 1140 CE traded at 48/-. The implied volatility was 48% and the 1140 PE traded at 47/-. The total premium received was 95 per lot.

I asked the same questions again (asked during the previous RBI trade), and received very similar answers. This is why I won't post the question and answer excerpt here.

Looking back at Infosys's Q2 results the market expected Infosys to announce a decent set of numbers. the no. are better than actually expected.Here are the details.

Infosys reported a net profit in July-September of $519 million compared to $511 million the previous year. Revenue rose 8.7% to $2.39 trillion. Sequentially, revenue increased 6%, exceeding market expectations of 4-4.5% growth.

On revenue of Rs. 3398 crore, rupee net profit rose 9.8%. Sources: Economic Times.

The announcement was made at 9:18 AM, three minutes after the market had opened. This trader did however manage to close the trade in the same time.

Here's a snapshot


(IMAGE 10).

The 1140 CE traded at 55/-, and implied volatility was down to 28%. The 1140 PE traded at 20/-, and implied volatility was down to 40%.

Pay attention to this: The speed at which a call option rose was slower than that at which a Put option fell in value. He made a 20-point profit per lot and the combined premium was 75.

My thoughts about this trade - It is clear that this trader has some experience. If I could execute this trade, I would likely do something very similar.

23.5 - The Infosys Q2 Aftermath (Fundamental).

The trade was done by a fellow Bangalorean. I am familiar with him. He has impressive fundamental analysis skills. With the goal of finding options trading opportunities, he has begun to experiment with options. His story would be fascinating to follow.

The background of the trade is provided below.

Infosys just announced a very good set of numbers, but the stock fell 5% on 12 th Oct and 1% on 13 th Oct.

Further research revealed that Infosys had cut their revenue guidance, which led to the stock being down. He believed the market had already considered this and that Infosys' revenue guidance reduction was a realistic assessment of the business. The stock fell 6%, however, which was not the reaction you would expect if markets had taken in the news.

He felt that market participants had overreacted to guidance values, to the point that they failed to see the positive side.

His belief was that if you present both good and bad news to the markets simultaneously, then the market will always respond first to bad news. This is exactly what Infosys was doing.

He chose to take a long position on a call option in the hope that the market would eventually react to Q2's results.
(IMAGE 11).

He bought Infosys's 1100 CE for 18.9/- slightly OTM. He intended to keep the trade open until the 1100 strike becomes ITM. He was willing to take a risk of Rs.8.9/$ on this trade. This meant that if Rs.10 drops to Rs.10, he would have to exit the trade and take a loss.

The stock bounced back after executing the trade and he was able to close the trade at 21 Oct.

Here's a snapshot
(IMAGE 12).

This trade netted him more than twice his initial investment. He must have found this a sweet deal

Realize that the entire logic of the trade was based on a simple understanding of financial statements, basic business principles, and options theory.

My thoughts about this trade - Personally, I wouldn't be uncomfortable initiating naked trading. The entry and stoploss were not supported by logic in this instance. The trader could have taken slightly higher OTM risks because there was plenty of time for expiry.

This concludes this module on Options Theory.

I hope that you find this information useful. I also hope it has a positive effect on your options trading strategies.

Best of luck.