Margin for Options

Hello everyone, welcome back. Hope you all had a great time during Diwali. I was back in Pune yesterday night and was waiting eagerly to get back to writing ways. Surprisingly, even during the vacation... thought of writing couple of times. Hope that's a good sign.

Anyways, have to keep Support and Resistance post on a hold for the time being. Reason is, along with Support and Resistance level, we will also discuss trading strategies depending on them. These strategies will necessarily involve selling options at times for which it is imperative that we understand how margins work for Options. Hope all of you have gone through the Margin Post on Futures Blog as we will use that as baseline here.

As we have seen in Futures Blog, margin consists of two parts - SPAN and MTM. However, in case of Options, it is different due to the inherent difference between Futures and Options. While both parties are bonded by Futures contract and have obligation to settle it; in Options only seller has the obligation. Buyer of Option has the right but not the obligation to fulfill his side of the bargain. So obviously no cracker or Diwali sweet for you to guess that a buyer of the Option does not have to pay any margin. He pays the premium upfront and that is as much deep as he can sink in it.

However, a seller (Option writer) receives the Premium for writing the Option. This premium is added to margin requirement and just like in case of Futures; it is calculated daily. If you recall the Option Pricing posts (this and this), Premium already covers the Intrinsic Value of underlying or in other words Mark to Market component. Not to forget, it also covers the volatility component within the Premium. This means premium of the Option theoretically covers SPAN as well as MTM part of contract. So if premium goes north/south, your margin requirement changes accordingly which you have to oblige. There is no MTM or SPAN as it is not needed and you have to make sure that the you keep the margin equal to or more than the current premium of the contract in the market. Another no brainer is that Margin does not go to ridiculously low levels even if Premium approaches zero as there is a minimum margin (Short Option Minimum Charge) that you have to keep with the exchange at all the times.

Will write more on Margin on Futures Blog in a while. Don't forget to read and comment. Also do let me know if you have any questions.

Welcome back once again... let's ride.

Happy Diwali

Rather than writing more about Support and Resistance as I said in the last post, today’s post is just to wish all of you and your loved ones a Very Happy, Joyous, Prosperous and Safe Diwali.

Also if you want to read something today please see my new post about Margin on Futures Blog and on Japanese Candlesticks on Equity Blog. Needless to say, will wait for your comments.

Next post will be on finding Support and Resistance again. It will be followed by long overdue post on Margin Calculations. For both these posts, it will be important for you to go through the posts on these two blogs. We will be using them as basis of our discussion.

Once again, wish you a Very Happy Diwali. Have a rocking time.

Support and Resistance Levels... without Charts

In the death overs of last post I said something about Supports and Resistance without charts... let’s see how we can do that.

Just a small detour before we get to that. As you guys know that I cannot and do not want to trade from office as far as possible. I can call up the broker if some really really great opportunity knocks but it has not happened so far. I only look at the market trend and do the predetermined trades based on homework a night before. I miss the college days for that freedom...

The point here is because of my inability to track the market hourly or daily… I work with weekly levels. I decide the Supports and Resistance based on weekly charts and accordingly open the trades. I try to close all my positions on Friday and start new positions on Monday. Another thing is I am not a compulsive trader... it is very dangerous thing to be and I will talk about it on Equity Blog. So I trade when I get the risk-profit ratio in my favor or suiting to my appetite or otherwise I simply let it pass.

Coming back to main objective of our post, I will explain how to find out Support and Resistance levels for the week based on data of previous week (disclaimer: I do not use this system anymore and prefer charting and hence have not used it for a long time).

First step is to find out Average Level of NIFTY for the week gone by and it can be done as below;

Avg Level = Avg (Highest Level, Lowest Level, Weekly Close)

From this 4 data points(3 levels of NIFTY and Avg Level as calculated) we can get Support and Resistance as below;

Support = 2 x Avg Level - Highest Level

Resistance = 2 x Avg Level - Lowest Level

Let’s see the illustration for the last week;

Highest Level = 5160.25 (Monday)

Lowest Level = 5011.05 (Tuesday)

Weekly Close = 5049.95

Avg Level = 5073.75

Support = 4987.25

Resistance = 5136.45

Have to rush someplace so follow up, comparison with charting levels, trade as per these levels and more in the next post.

Support and Resistance Levels...

Thanks a lot guys for your support messages.

Will get straight to the point. In the last post, we saw how to identify the intra-day trend for the market. Now once we have identified the trend, next obvious question comes to the mind is which Strike Price you should trade on. I mean, let us say NIFTY today is around 5000 and you have identified Up trend. Now should you be buying something at 5000 Strike, 4900 or 5100 or what?

This is where our two beloved, most used friends, Support and Resistance enter. It is very unlikely that you have not heard of these terms even if you are very new to the market. Though these terms are associated with Technical Analysis and Charts, still, I will try to give some very basic idea here. Detailed posts on these will be made on my Equity Blog.

Support and Resistance, both these are levels which act as barriers for the NIFTY (or any index or stock for that matter) to move beyond. Obviously, Support is a level NIFTY finds tough to go below. Resistance is a level which NIFTY finds it difficult to cross on the up side. The simple explanation of these levels is something like this; Support is a level where lot of buyers think that it is a fair level to buy and they step in outnumbering the sellers and hence price does not go below it. Resistance is a level where lot of people think that profit should be booked and sellers exit in large number outnumbering the buyers and hence price finds it difficult to go beyond this point.

Once you have the chart of NIFTY or entity under consideration, there are many ways to ascertain these levels. Some of the most prevalent methods are;

• Horizontal Price Levels
• Trend Lines
• Moving Averages
• Fibonacci Retracement Levels
• and sometimes Round Numbers too

How badly I wish that I could write more on each of these but this is not the right place and time. As I said, I will write all (really a lot of stuff) on Technical Analysis on Equity Blog and it surely seems that I cannot delay it any further. Will start working on that too... stay tuned and keep them comments pouring in.

Few things before I close this post. First, nothing is forever... so Support and Resistance levels are broken and it happens more frequently than one thinks. Second, for every chart, there are many Supports and Resistances and they need to be chosen carefully. We will address that too.

Finally, what if you do not have any charting software and data. There are two ways to solve this... first being free charts available on many websites including NSE, Moneycontrol, etc. Second, if you are not at all interested in charting and belong to good old pre-charting classic school, we have a way to find these levels (which may not exactly match charts but will work for us nonetheless) by pure calculator means. Will write next post on that.

Have great support and zero resistance for Diwali Shopping.

How to identify the trend of the Market...

Hey guys, I can't apologize enough. Honestly, I am trying my best to get back to writing again but somehow it is just not happening. Many of you already know that the trek on last day of our training was very hectic for me and I could not feel many of my body parts for last two days and many of the body parts I felt for the first time in my life in last two days.

Anyways, I will not get in to reasons now and will simply do what I enjoy most... writing here. Before I go ahead I hope you have read couple of posts I made on Futures Blog. Do let me know your comments.

Well, this is one post which I am longing to write for some time now. It is regarding how to find the trend in the market. Obviously I am not talking long term or mid term trend here and I am referring only to the intra-day trend here. It is this trend which will help us make our trades. Now, whatever I am writing here, is not something technical or it is not something which is created by me. In my early days as a trader, I read someone advising similar strategy which I have tested and customized a little such that it works for me 75% of time. If I ride my gains and cut my losses by keeping stop loss and respecting them, believe me 75% is a good number.

Well, since now NIFTY is in pre-open between 9:00 to 9:15 and is off the bounds for poor souls like I and you... I take a first look at the market at 9:20. This is the opening price of NIFTY for me after initial noise has subsided.

At around 10:20 to 10:30, I look at the NIFTY again and see if the level is at least 20-25 points above or below the opening price. This is first trend check and based on the confirmation in the positive side or negative side I make the first trade of the day. Not to mention again but I keep a stop loss for every trade.

At around 12:45 to 13:00, I take stock of the NIFTY once again. If there is difference of 20-25 points with respect to level at 10:20 or 10:30 then the market is still trending (it could be in opposite direction). I make some adjustment to the trade at this level by opening additional position or partially closing some.

One final check I do at 15:00 to 15:15 to see how the trades are faring and either close my positions fully or if I decide to carry them in to next day then I convert them in strangle or straddle depending on what the market is saying. Remember, I will advise never to carry an unilateral position overnight unless your risk appetite is high. Also make sure that your broker does not automatically convert your intra-day position in to delivery positions at 15:00 or otherwise you need to change the timings a bit to suit yourself.

These timings and difference of 20-25 points, though I try to stick to them, are not sacrosanct and you can choose to modify them for your convenience. Also when you do not see any trend and market is just moving sideways, your trades can be different or sometimes the best trade is no trade after all (Some of these important things I intend to write on Equity Blog).

Also, it is important to identify the mid term and long term trend of the market even while trading for the day. For this, you need technical analysis and charting knowledge as well as some interpretation tips. I intend to write about it on Equity Blog very soon. You won't believe it but I have been writing posts on all the three blogs in my mind and have already couple of posts ready for each blog. Unfortunately not being able to convert them to actual posts. Pray for me that I am better at doing that here onwards and also let me know how did you like the straw-berries.

Lets summarize...

I told you that I will be posting real soon and you thought that I was joking... huh?

Since I am short on resources here, I thought I will use this opportunity (just learned today that every difficulty is opportunity… no kidding) to summarise our journey so far.

Well, those of you who have not been with me since start, we started with answering the question; Why Options? and then understanding What are Options? Then we checked on various terms and their meanings in option definitions, more definitions and then some more. We discussed terms such as underlying, premium, strike, expiry date. We also touched upon lot sizes and various underlying and their lot sizes.

We then got started with very important Option Pricing and Option Pricing. No, its not a typo. We actually did two posts on that. Then came the turn of variation of premium as the expiry date approaches.

At this point we have had enough of fundas and we started with trading strategies like Buying a Call, Buying a Put and then simple yet very effective Long Straddle and Long Strangle.

Never mind if you have missed any of above. However, I will strongly advise... rather insist that you read this as you follow this blog.

Looking back, I never thought that I will reach this far but we have covered lot of ground and I am really proud of this blog. I promise that I will make up for lost time and will surely write a post tomorrow which will take our discussion forward. Keep waiting for straw-berries...

Sorry friends... been busy.

My endless apologies for this break in posting. But I have multiple reasons;

First, since Saturday I am in Panchagani along with my full Project team undergoing training. I could have still managed an earlier post but for the rumour that Aamir Khan is in Panchagani and one of my friend literally dragged me to his Bungalow here every evening. Sad for her and for me too (though for different reasons) we did not get to have a cuppa latte with him.

Another reason is my Tata Photon just wouldn’t work here and right now too I am working with the borrowed connection from my PM (She is a real nice lady).

One unbearable thing (at least for first two days) is lack of update from market. Not that I had any open positions but was not even able to check market direction barring today.

However, today I strongly felt that such break once in a while is a damn good thing. You can put lot of things in perspective.

Just to elaborate what I mean, I read an article somewhere which was something like, World, as we know it, is going to end but I am not worried. Author says, doomsayers have long been predicting apocalypse for the markets for every possible reason. It was thought that after Lehman collapse, we will be stuck there forever. Dubai world, Ireland default were supposed to be extremely dangerous for world markets. Japan Tsunami was something of a bear conspiracy to keep the market subdued for long.

What happened? All these events created panic for sure. Today also things are more or less same with Dubai or Ireland but markets are not talking about them. Today we have new favourites… Greece, Euro zone, US debt ceiling, China housing collapse, etc. So either we really like the bad news (and get tired of it very soon too) or we simply do not understand markets enough. I will vote for second option any time of the day.

Summing it up, Greece too will probably pass either with a bailout from Euro zone, through a default or through a break-up from Euro. Question is, in larger scheme of things, how much long lasting difference it will make or Markets will simply shrug it after momentary hiccups and carry on with business as usual? Remains to be seen and we will see it together and we will ride it together.

Another apology for this rather philosophical and loud thinking post in between which must be the effect of Yoga and Pranayam training we are having every morning. I will surely post another sooner than you think. Please bear with me for this turbulence till this Sunday. I will get wonderful and extremely fresh straw-berries for you from here.

Trading Options - Long Strangle

So what is Strangle?

Just like in previous post, you are unsure of direction of the big move. However you have inkling that it is more likely will be in positive direction. At the same time, you don’t want to bet in one single direction and want to cut your losses in case you are wrong.

So Strangle comes to your rescue. Only difference between Straddle and Strangle is that the Strike Price of the Call and Put options is different. In Strangle for our scenario, you buy 5000 Call option for 100 Rs premium (5000 Rs) but while buying Put option, you buy 4800 Put for 25 Rs premium (25 x 50 = 1250 Rs). What this basically does is that your break-even point on the (more likely) positive side is reduced and you start making money as soon as NIFTY crosses 5125 level. Graph is once again helping us understand it.

You are making money earlier in positive direction and at the same time you are protected from extreme downside. So if market drops sharply, your put option gains in value. It reduces your overall loss or in extreme down move, you can still make money albeit a little less. Break-even on upside is 5125 and on the downside 4675. You are in a better position to benefit more and sooner from the positive move (which we believe is more likely at the start) and still have some protection from the downside. Like in previous post, this is a long strangle.

Now, let us talk about not holding these positions till expiry date as we have been assuming for last three posts. Take example of Strangle trade in this post. If you see that you are wrong and market is moving in opposite (negative) direction, the Call Option premium will start dropping. So rather than holding it till very last date… you square off your Call position (you sell the same option) back in the market for let us say 50 Rs Premium losing 2500 Rs ((100-50) x 50 = 2500 Rs).

At the same time, since market is moving in negative direction, your Put Option premium will rise in value and 25 Rs premium may quickly jump to 50 Rs. Since the market is anyway moving in negative direction, you may want to hold Put Option a little longer and actually recover entire loss in Call premium through you Put position. Strangle is usually more popular and practical strategy for newbies.

For executing any of this, you will have to be an active trader and keep a decently continuous eye on the market. And I cannot over emphasize importance of Stop-Loss (details and how to use it will be explained in some other post) in these trades. If you have any questions so far, feel free to shoot them to me. Rest assured, I will not try to dodge them.

Trading Options - Long Straddle

If you are sure about a big move in Market but not sure about the direction, straddle and strangle are two options strategies that are tailor made for you. Both strategies consist of buying an equal number of call and put options with the same expiration date. There is slight difference between the two though.

First let us understand Straddle.

In this case, you just buy a Call Option and a Put Option for same Strike Price and same Expiry. Continuing from previous two posts, let’s say you buy 5000 Call and 5000 Put for 100 Rs Premium each and lot size is off course 50 (You pay 5000 + 5000 = 10000 Premium). Now when the budget is announced, market reacts sharply either in positive or negative direction with a big move. Following graph shows your Profit/Loss with respect to NIFTY level. Please note that, in this case too we are assuming that you continue to hold both the positions till expiry date. Usually you don’t do that and hence either your losses are much less and your profits are little higher. We will explain that too in some other post.

So basically, 4800-5200 is the range where you do not earn money. When NIFTY moves beyond this range then you start making money. E.g. At NIFTY of 5100 you recover 100 Rs premium through you call option but still you have lost your 100 Rs premium of put. When NIFTY moves beyond 5200 then both your premiums have been recovered and you start counting your blessings.

Please try to understand that this strategy is very useful when there is some big move in the market. In a sideways market, you are more likely to lose your premium and hence it must be used only in strongly trending or news based market. Moreover, when there is expected to be a big move, option premiums tend to increase so your overall profit is affected to some extent. Try checking Infosys option chain premiums near their result date.

One more thing, buying straddle here is referred as Long Straddle. You can also sell straddle and there is no price for guessing its name as Short Straddle. We will discuss about it when we get to selling options.

For other scenarios, we always have Strangle. You will have to wait till next post though…

Strategy - Buying a Put

Continuing from where we left in the last post…

This time, let us say that your analysis shows that there is a good probability that NIFTY will be going south by the target expiry date. Since you do not want to bet on one of the 50 stocks of NIFTY, you simply buy NIFTY Put Option. Let us say you buy NIFTY 5000 Put at 100 Rs Premium (100 x 50 lot size = 5000 Rs) and then as in previous post, you forget it… you do not square it off and sell your position. You wait till the expiry date for exchange to settle your option. Below figure tells you what is your profit or loss from this transaction depending on various levels of NIFTY.

Everything in last post also applies here. As you will see, if NIFTY is above 5000, you have lost your premium in total because you have bet NIFTY to fall and Put option above strike price is worthless. If NIFTY is between 5000 and 4900 then you recover some of your premium. Let’s say NIFTY is at 4930, so exchange gives you 3500 Rs (70 x 50 lot size) and your loss if 1500 Rs. In case, your analysis is correct and NIFTY lost much more and settled below 4900 then your trade is in profit at expiry and your profits are directly proportional to NIFTY level below 4900. E.g. if NIFTY is at 4800, exchange will give 10000 Rs (200 x 50) and you would have made 5000 profit after removing the 5000 Rs premium you paid.

It’s very simple so far… right? But what do you do when you are not sure of direction of the market? Let us say that you are pretty sure that after the RBI meet (or budget) market is going to react sharply. In which direction? You have no idea. You are pretty sure about the big move but you do not have any inside information about RBI Policy or Budget Provisions (welcome to the majority)…

Don’t worry, help is at hand. There are strategies which help you take advantage of such situation too. Stay tuned for next post…

Oh yes, I wish Happy Dassera to all of you and your families. Have a great time.

Strategy - Buying a Call

Let us start with the simplest of Option trading… plain vanilla buying of Options.

So let us say that your analysis shows (not just you feel) that there is a good probability (not certainty… isn’t it?) of NIFTY increasing in value by the target expiry date. Since you do not want to bet on one of the 50 stocks of NIFTY, you simply buy NIFTY Call Option. Let us say you buy NIFTY 5000 Call at 100 Rs Premium (100 x 50 lot size = 5000 Rs) and then you forget it… you do not square it off or sell your position. You wait till the expiry date for exchange to auto settle your option. Graph below tells you what is your profit or loss from this transaction depending on various levels of NIFTY.

As you will see, if NIFTY is below 5000, you have lost your premium in total because Call option below strike price expires worthless. If NIFTY is between 5000 and 5100 then you recover some of your premium. Let’s say NIFTY is at 5070, so exchange gives you 3500 Rs (70 x 50 lot size) and your loss if 1500 Rs. In case, your analysis is correct and NIFTY increased much more than 5100 then your trade is in profit at expiry and your profits are directly proportional to NIFTY level above 5100. E.g. if NIFTY is at 5200, exchange will give 10000 Rs (200 x 50) and you would have made 5000 profit on 5000 premium. That is a whopping 100%.

This brings us to another important factor in Derivative trading; Leverage. If you were to invest 5000 in a stock and wait till it doubles it would probably take few years. In case of derivatives it can happen in a very quick time. There were times when I have made more than 200% profits on trades. Not to forget, it is not rosy picture all the time on this path. Downside of leverage is you can lose money equally fast. So instead of making 5000 Rs you can simply lose entire 5000 Rs if NIFTY is below your strike in this case. I have been through such situation too.

When you are buying option you cannot lose more than 100% of your Premium and hence you know the worst case scenario right away. But you are exposed to much higher risk when you sell the Options. That is why it is recommended to start with buying options as you experiment and learn the tricks of the trade.

Life is anyway short to make all the mistakes yourself and learn from them. It is worthwhile to learn from other's mistakes too. I have made many and observed many more. Let's shorten our learning curve.

Option Price Variation

Below is the table which shows variation in the premium of option over a period of time as I promised in the previous post.

This table shows variation of NIFTY 5000-CE-29-SEP (NIFTY Strike Price 5000, Call Option, Expiry on 29-Sept-2011) Option Premium with respect to time.

Traditional wisdom says that Time Value of this Option should drop as it approaches expiry however the same is not seen here. The explanation lies in the increased volatility. If you can recall, in the last couple of weeks we have had many 3%-5% drop/rise days due to unraveling of US and Europe crisis. I could have included Volatility Index (VIX) and also highest/lowest levels of NIFTY and many more factors but that would have only complicated the table.

As of now, the only takeaway from this table is normal things do not happen during abnormal times...;-)

Well, about next post,  initially, we will have to discuss strategies and trades that will involve only buying of options. I will have to make a post on margin calculation before we get to selling options. Yes, we will also talk about selling options... yes, yes selling options, you read it right. Yeah, I know every piece of information out there suggests that it is very risky and all that but with little bit of ingenuity the risk of it can be reduced to a manageable level if not altogether eliminated. We will see...

Option Pricing

There are many factors which determine Option Premium. These factors affect the premium of the option with varying intensity. Some of these factors are listed here;

Price of the Underlying: Any fluctuation in the price of the underlying (stock/index/commodity) obviously has the largest impact on premium of an option contract. An increase in the underlying price increases the premium of call option and decreases the premium of put option. Reverse is true when underlying price decreases.

Strike Price: How far is the strike price from spot also has an impact on option premium. Say, if NIFTY goes from 5000 to 5100 the premium of 5000/5100 strike will change a lot compared to a contract with strike of 5500 or 4700.

Time till Expiry: Lesser the time to expiry, option premium follows the intrinsic value more closely. On the expiry date Time Value approaches zero.

Volatility of Underlying: Underlying security is a constantly changing entity. The degree by which its price fluctuates can be termed as volatility. So a share which fluctuates 5% on either side on daily basis is said to have more volatility than let’s say a stable blue chip shares whose fluctuation is more benign at 2-3%. Volatility affects calls and puts alike. Higher volatility increases the option premium because of greater risk it brings to the seller.

Apart from above, other factors like bond yield (or interest rate) also affect the premium. This is due to the fact that the money invested by the seller can earn this risk free income if invested in bonds and hence while selling option; he has to earn more than this because of higher risk he is taking.

Sometimes dividend payment by an underlying is also factored in to the premium as it affects the cost of buying those shares directly rather than buying the option.

There are other factors too which I will touch upon as and when opportunity presents itself during our trading posts and strategies.

Fortunately for us we do not have to take all these factors and do some complex spreadsheet calculation for finding out premium. There are many models developed for options pricing one of which (and most popular) is Black & Scholes pricing model. The two professors, Fischer Black & Myron Scholes, won a Nobel Prize in Economics for its creation. Though its knowledge is not a precursor to options trading, a little bit extra knowledge has not killed anybody.  At least not anyone I know of. Read about it here and let me know if you felt any uneasiness after reading it.

I will post a table which shows variation in the premium of option over a period of time in next post.

Stay tuned and fasten your seat belt as the ride is gonna get bumpy here after...