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Charts & Analysis

A story about trading options

Nifty closed at 4412 today. I’d mentioned to a friend on Monday, when the market was around 4300 or so, that the options data seemed to suggest that the market would move upwards rapidly in two days, and end near the 4400 levels.

What happened seems to have come through, but this just a thought that I haven’t yet verified with past data. It seems to me that when is too much money riding on the fact that the market will go DOWN, it does the exact opposite.

The three options with the highest open interest on Wednesday were: the 4300 put, the 4400 put and the 4500 put. Together these accounted for an interest of around 99 lakh Nifty shares, an amount equivalent to 4300 cr.

My feeling was, when the put options have so much interest, they will make a lot of money when the stock price is below their strike price. In general, markets will move against where most people go – therefore, the price that looked most obvious from the data was 4400. The 4500 put traded much higher than Rs. 100 giving it a real value only when the Nifty was below 4400.

The upmove on Monday solidified that thought, since Friday was a bleak day for the US markets and we were supposed to follow suit. When Tuesday followed high, I took a position on the Nifty on Wednesday, writing a 4300 put, in my belief that the Nifty would end above 4300. A put-writer – or a seller of a put – is obligated to BUY at a certain price. My 4300 put-write gave me the obligation to buy the Nifty at 4300 on Thursday, one days later. Note that at this point, the Nifty was trading above 4300, so the premium I got was about Rs. 20. For one lot of 50 Nifty, I got about Rs. 1,000.

The margin I paid was Rs. 20,000 or so.

Now on Thursday the market rocketed upwards. It ended at 4412, nearly a 100 points up from where I had written it. Since selling me the Nifty at 4300 was useless, the option would be unexercised, giving me the Rs. 1,000 profit. What did I invest? Rs. 20,000 – the margin I put for writing the put.

Options are very risky; in fact, had I done this on Tuesday I would have been in some temporary trouble. Nifty ended up on Tuesday at 4300, and the put quoted at Rs. 20 then. The next day the market opened low, and the option was at Rs. 70 – a Rs. 50 loss. That means a loss of Rs. 2,500 per lot – a 13% loss in just one day! Yet the Nifty recovered and made the position a profitable one.

Most people who trade in options tend to buy them, but a lot of money can be made writing options, especially close to expiry. To me, it looked like the market would move against those that had bought options (because they have a limited risk – the option writers have unlimited risk), especially against the 4300 put because the open interest on that option was going UP when it should be declining (typically, option open interest in the last few days before expiry, declines)

So would I go and write all the top open-interest options the day before expiry? No. There needs to be a clear trend – increasing interest in a certain type of option and the direction of the top traded options. And I need to statistically analyse if such a strategy would have worked in the past – otherwise this is just co-incidence.

Note that commissions can put you out of business too. My commissions and taxes on my option was only Rs. 60, because I used Reliance Money. Had I used my account at Sharekhan I would have paid at least Rs. 250, a considerably lower profit.

If you have ABSOLUTELY no idea what this article was about, you probably want to read my Introduction to futures and options article.