In settlement week, there is always a temptation to exploit higher volatility combined to lower option premiums. Settlement means higher volatility. At the same time, the expiry effect ensures options slightly far from money trade cheap. An intra-day swing can, therefore, set up a huge return.
There are sophisticated formulae for judging when options are under-priced, in terms of implied and historical volatility. However, when it’s just two sessions to settlement, one can use a few simple rules of thumb.
For example, the average daily high-low swing for the Nifty has been 97 points in the September settlement and the standard deviation has been 28. In addition, the market has opened with a gap of an average of 38 points away (high or low) from the previous close. The opening gap has a standard deviation of 29.
There is a good chance that one of the last two sessions going into settlement will see a high-low move of average plus one standard deviation, that is, 125 points. Given the opening gap history, there is a fair chance of a session with an intra-day move of 150-160 points away from the previous close. By the same logic, a move outside two standard deviation plus the opening gap – a swing of 190-plus points is not likely.
The closing Nifty value on Tuesday was 4,971. It’s reasonable to expect a move till around 4,725-4,750, or a move till about 5,100-5,125 within the next two sessions.
First, assume the trader has no directional bias. One strategy is to create a long strangle of long September 4,800p (premium 5) and long 5,100c (7). This would at least double in value if either strike is hit. Another method is to take a short strangle at short 5,200c (1.5) and short 4,700p (2.5) assuming you can find a counter-party. This won’t fetch much but it’s reasonably safe. Combining the two gives a long-short strangle combo that costs a net 8. This could fetch 200 per cent returns or more, if either long option is struck.
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With directional bias, the low-risk strategy is a bullspread or bearspread. Essentially this would be either the long 5,100c-short 5,200c combination or the long 4,800p- short 4,700p combination. Again, there is the chance of a huge payoff, given a swing session in the right direction.
A more conservative directional method is to take a call or put butterfly. If you’re bearish for instance, a long 5,000p (49), two short 4,900p (2x16) and a long 4,800p (5) costs 22. This pays off if the Nifty moves somewhere within the range of 4,822-4,978 with a maximum gain of 78 at 4,900. A butterfly has high brokerage costs. But it also has an extremely good chance of pay offs.
The author is a technical and equity analyst