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This chapter's title might be confusing. We have covered the options concept in 21 chapters.Now we will revise the ''call & Put option''. We actually started this module by talking about the Call & Put options. So why are we doing it again?
This is because I believe there are two levels to options learning - one before and one after you discover the option Greeks. After we've spent some time learning Option Greeks, it might be time to reexamine the basics of call and put options. Keep the option Greeks in mind.
Let's take a quick overview.
The first few chapters provided a basic understanding of the call and put option basics. But the goal is to now understand the basics and keep volatility and time in perspective. Let's get started.
It is a common practice to purchase a Call Option when the underlying asset is expected to rise higher. Let's assume Nifty will rise by a certain percentage. Would you then buy a Call Option if this happened?
These questions show that it isn't easy to buy a call option or put option. Before you can buy an option, there is some groundwork. Groundwork mainly involves assessing volatility, expiry time, and the directional movement in the market.
I won't discuss the market direction assessment here. This is something that you will need to do yourself, based on theories like technical analysis or quantitative analysis, or any other suitable technique.
Technical analysis could be used to determine that Nifty will rise by between 2 and 3 percent over the next few trading days. If it was already known,what would you have done? What would you do? Would you choose to buy an ITM or ATM option? Nifty will rise by 2-3% in the next two days. Which strike is the best for you? This is what I want to talk about in this chapter.
Let's begin by looking at this graph. If you remember, we talked about it in the chapter on Vega.
(IMAGE 1)
The graph below shows how call option premiums react to volatility increases across different time periods. The blue line, for example, shows how a call option premium reacts to volatility when there are 30 days left before expiry. Green for 15 days, red for five days.
The graph below can help us to draw some practical conclusions that we can use when buying/selling calls options
Here's the graph showing the premium for putting options versus volatility.
(IMAGE 2
This graph is very similar in appearance to the graph of volatility versus call premium. Therefore, the same conclusions can be drawn for put options.
These results make it clear that you should buy options if volatility is expected to rise and short options if volatility is expected to decrease. The next question is: Which strike should you choose to purchase or sell options? Here is where you need to assess the time until expiry.
Let's assume volatility will increase with an increase in underlying prices. It is clear that buying a call option is a good idea. But it is more important to choose the right strike to purchase. It is crucial to determine the market expiry distance before you buy an option. The time of expiry will determine the strike.
It is possible to understand the chart by looking at it from different angles. Don't be discouraged if you don’t understand the chart the first time. Just keep trying.
First, we must understand the timelines before we move forward. The average F&O series lasts for 30 days, except in the February series. To make it easier to understand, I've divided the series into two halves. The first half refers the first 15 days of a series, while the second half refers the last 15 days. This will help you keep your eyes on the bigger picture as you read below.
Take a look below at the four bar charts that represent the profitability of various strikes. This chart assumes that -
The chart shows the results of the above. It attempts to determine which strike is most profitable if the target of 4% can be achieved within -.
Here's a classic example: Today is 7 th Oct. Infosys results today are 12 th Oct. You are bullish about the results. If you were to purchase a call option and intend to square it off in five days, which strike would that be?
It is obvious from the chart that when there is enough time for expiry (remember, we are at some point during the 1 st-half of the series), and the stock is moving in the expected direction, all strikes tend to make profit. OTM options are the best option, but strikes that make maximum profit are far from OTM. The chart shows that maximum money is made by the 5400 and 5500 strikes.
Conclusion If we are in the first st 50% of the expiry sequence, and you anticipate the target being achieved quickly (say within a few days), then buy OTM options. I recommend that you only buy 2 to 3 strikes from ATMs and not more.
The 2 chart (top left) shows that trades are executed in the st 50% of series. Stocks are expected to move by 4% but the target is to be met in 15 days. Everything else is the same, except for the target to be reached and the time frame. You can see how profitability changes. It is clear that buying OTM options far away makes no sense. These OTM options can even cause you to lose money (see the profitability of 5500 strike).
Conclusion If we are in the 1 st 50% of the expiry sequence, and you anticipate that the target will be met within 15 days, then it makes sense for us to purchase ATM or slightly OTM options. I wouldn't recommend purchasing options more than one strike from ATM. Avoid buying OTM options that are more than 1 strike away from ATM.
The 3 row chart (bottom right) trades are executed in the st 50% of the series. While the target expectation (4% move), remains the same, the target timeframe is different. The target should be reached 25 days after trade execution. As you can see, OTM options are not worthwhile to buy. OTM options can lead to losing money in most cases.Buying an ITM option is always a better option.
At this point, I must mention that OTM options are often purchased because they have lower premiums. Don't fall for the illusion that OTM options have a low premium. However, even though you may not lose much, there is a high chance you will lose all your money. This is especially true when the market moves at a slow pace. If the market moves 4%, but spreads over 15 days, it is not a good idea to hold far OTM options. Far OTM options can make money if the market moves quickly - such as a move of 4% in a matter of days or less. Far OTM options can move smartly when this happens.
Conclusion When the expiry series is at its beginning and you anticipate that the target will be met in 25 days, then it makes sense for ITM options to be purchased. Avoid buying ATM and OTM options.
The last chart (bottom left) is very similar to the 3 charts, except that the target should be reached on the day of expiry (or close to expiry). The conclusion states that all options, except ITM, will lose money in such a scenario. Avoid buying ATM and OTM options by traders.
Let's look at another set. The idea is to determine which strikes to choose, given that the trade takes place in the 2 nd half the series. That is, at any time between the 15 th month and the expiry. Keep in mind that time decay accelerates during this period. As we get closer to expiry, the dynamic of the options changes.
These 4 charts help us to identify the best strike for each time frame during which we can achieve the target. We do all this while keeping theta in context.
(IMAGE 4).
Chart 1 (top right) shows the profitability of various strikes. The trade is executed in the 2 and nd halves of the series, with the target being achieved on the same day as trade initiation. A classic example is buying an option due to news announcements. Another example is buying an index option based upon the RBI's monetary policy decision. As you can see, all strikes make money when the target has been met on the same day. However, the greatest impact would be on OTM options.
Remember the discussion that we had earlier: When the market moves quickly (like 4% per day), the best strikes are always OTM.
Conclusion If you anticipate that the target will be reached the same day, regardless of expiry time, buy far OTM options. I recommend that you only buy strikes within a few hundred miles of ATM options. It is not worth buying ITM options or ATM options.
Chart 2 (top left) shows the profitability of various strikes. The trade must be executed within the 2 and half of each series. The target must be achieved within five days. You can see how far OTM options lose profitability. The target was expected to be reached in one day in the case above (chart 1), so buying far OTM options made sense. However, here the target can be met in five days. Because the trade is open for 5 consecutive days, especially during the 2 nd halves of the series, the effect of theta will be greater. It is not worth taking on far OTM options. Strikes that are slightly OTM are the best bet in such a situation.
Conclusion If you're in the 2 and nd halves of the series and expect to reach the target within 5 days of trade execution, you should consider buying strikes that are slightly OTM. I recommend that you only buy one strike from ATM options.
Chart 3 (bottom left), and Chart 4 (bottom right), - these charts look similar, except that chart 3 targets are achieved within 10 days of trade initiation, while chart 4 targets are expected to be met on the day after expiry. The difference in days is not significant, so I think they should be considered similar. Both these charts can be combined to reach 1 conclusion. Far OTM options lose money when the expiry date is near. The far OTM options that are closer to expiry tend to bleed more quickly. ATM and slightly ITM options are the only ones that can make you money.
Although the discussions have been about buying call options, similar observations can also be made about PUT options. These two charts will help you understand which strikes to purchase in different situations.
These charts allow us to understand which strikes we should trade when a trade is initiated within the first half. The target can also be achieved in different time periods.
(IMAGE 5)
These charts can help us to understand which strikes we should trade. The trade is executed in the 2 second half the series. The target is attained under different time frames.
(IMAGE 6).
You will see that the same conclusions as for the Call options also apply to the Put options if you carefully review the charts. This allows us to generalize the best buying options.
(CHART)
When you plan to buy a naked call or put option, map the period (1 st 50% or 2 nd 50% of the series) as well as the timeframe during which you expect to achieve the target. Using the table above, you'll be able to identify which strikes you should trade and which strikes you should avoid buying.
We are now close to the completion of this module. The next chapter will discuss the simple trades I have initiated in the past few days. I will also share the trade reasoning behind each trade. I hope you will find the next chapter helpful in understanding the basic thought process behind simple options trades.