Posts Tagged ‘Strike price

29
Jun
11

Volatility smile

As option trader, the most crucial thing one has to observe is Implied Volatility (IV). When IV of an option and its strike price is plotted, its curve is known as volatility smile. Volatility smile for FX options is U shaped curve which resembles smile. FX volatility smile curve implies that IV’s for At-the-money (ATM) options are lowest, and higher for In-the-money (ITM) and Out-of-the-money (OTM) options.

For equity options, volatility smile tends to be downward sloping. IV decreases as strike price increases. After 1987 US market crash, people are worried about rapidly falling share prices and buy OTM puts as insurance. OTM puts IV’s are higher than ATM and ITM puts.

In one of my previous post https://writingoptions.wordpress.com/2011/06/10/dead-cat-bounce-and-my-dream-company-reliance-communications/, I had written that Reliance Communications (RCom) options have higher IV’s. I thought I should plot volatility smile for RCom calls and puts.

RCom put exhibit typical bookish pattern of reverse skew with ATM puts having lowest IV’s. OTM puts have highest IV’s followed by ITM puts.

RCom Call exhibit forward skew with OTM calls having highest IV’s followed by ATM calls and ITM calls. Normally commodities exhibit forward skew when prices are expected to rise in future.

Reliance Industries (RIL) is struggling on various fronts and this reflects in its share price performance over the past several months. So I thought about plotting volatility smile curve for RIL also.

RIL puts exhibit downward sloping volatility smile curve with OTM puts having highest IV’s, followed by ATM and ITM puts.

RIL calls volatility smile curve exhibit a shape similar to that of currencies. Its shape is different from RCom call volatility smile curve.

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13
Jun
11

Straddle : difficult to make money

Just read an article on buying straddles into earning season http://www.theoptionsguide.com/buying-straddles-into-earnings.aspx. Somehow I am not completely sure if, one can make money by buying straddles.

Straddle is a simple option strategy where, one buy call and put at same strike price expecting a big  movement in either direction but not sure which way. Problem here is that, both call and put are At the Money (ATM) options, hence have high premium. It takes a lot of movement in either direction to recover premium cost and make money. For e.g. , if one knew of coming SBI Q4 2011 disaster, straddle would have made money. Otherwise, in most of the cases one loses money on time decay. Straddle can be useful in case, stock has run up too much and slight disappointment in terms of result will lead to big down-move. In case, the stock has been under performing till results, slight improvement can lead to a big up-move. In both the cases, up-move and down-move has to be more than 5-6% to be profitable. In my previous post https://writingoptions.wordpress.com/2011/06/11/why-did-i-trust-this-congress-government/ I had mentioned about buying strangle to benefit from increased volatility in Cairn India. Earlier, I had given a thought to buying a straddle in Cairn India, but decided against it after looking at 340 Call and 340 put premium (Rs 11 each). Large movement  of Rs. 22 was required on either side to become profitable, which is approximately 6% of the 340 strike price.

Pay-off diagram for Cairn 340 Straddle:

04
Jun
11

First post

I have been writing options for quite some time. Writing or selling options is quite risky since your gains are limited to premium collected while your loss is unlimited, as shown by the black swan event like 2008 market crash across the world. As option writer, one stands to benefit from Implied Volatility(IV) and Time decay. IV as implied by the option premium, is the rate and magnitude of change in underlying prices. Time decay says that if underlying does not move much then, option will expire worthless (represented by greek theta). Anyways, options are wasting assets and their value declines over time.

Trading in options has increased significantly in Indian markets over last year and this is reflected in falling margins of major brokerage houses. Within option segment, Index options attract majority of volumes.

If you think market or stocks will remain range bound over extended period of time then, option writing is the way to go. Normally, I write Out of Money(OTM) Calls on individual stocks and rarely OTM Puts. First of all, I identify stocks which have announced either poor results or affected by any new development or major event which will impact their business significantly. Usually, these stocks take some time to recover and you stand to benefit from time decay. For e.g. – Infosys announced its Q4, 2011 results in April this year and market didn’t like its performance which was evident in stock reaction that fell 7 odd percentage. One could have easily sold its OTM Calls at 3300 or 3200 strike price and made quite a bit of money. Given the kind of selling which Infosys witnessed on huge volumes, it was extremely difficult for Infosys to go back and test 3200-3300 levels. I sold one 3300 Call for May series which was trading at Rs 19 that time. Writing options usually involve some kind of margin commitment and hence you calculate returns on margin provided. My returns on writing Infosys call were 4.59% in 18 days, which is quite decent by any standard.

Over next several posts, I will keep giving examples of trades which I have executed or about to execute. I believe, writing options if done sensibly can yield 25% annualized returns.




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