Why NOT option strategies?

Trading volumes of options are raising faster among other derivatives in India. One of the reason could be that small retail investors are able to place a bet on the market by buying OTM options.

However there is a difficulty. This weird thing called theta decay eats up option premium really fast leaving option buyers high and dry. Buying option at higher implied volatility is pretty horrible thing to do. Higher the implied volatility, higher the cost of options. Premium loss due to theta decay is quick and accelerates every day. If nothing else kills an option buyer, then time decay will happily do it.

As IV raises so is the theta decay on options

Although Nifty VIX has been falling for few days, it is still very high. These days implied volatility of Nifty OTM options are upwards of 50-60%.

So what can be we do about it?

Can retail traders instead try writing (sell) OTM options. Probably not. One because writing plain options aka. naked writing is very risky in these uncertain times. A few large losses could totally wipe out the trader. Second the margin for option writing is higher than that is required for futures trading. Margins requirements for writing naked options are only going to get higher with SEBI margin rules kicking in soon.

How about futures trading then? Futures are pure directional plays which does well in a trending phase. Hmm.. but about 70-80% of the time market coils and that's not good for future traders. During the sideways phase, futures can chop traders on both sides. But biggest worry for futures trader is carrying the position overnight and subject themselves to nasty gap opening risk. Nifty is notorious for its gap openings almost on daily basis. Hence future trading is most suitable for Intraday trading.

For swing trades, option spreads offer a low risk alternative. It offers best of both world of option selling and buying.

What are option spreads? Its a strategy typically involving two or more options on the same, single underlying asset such as Nifty or Bank Nifty. For example a debit-vertical-bull spread on Nifty may involve buying ATM call and at the same time selling OTM call 100 point or so away from spot price. In this case the trader will pay a net debit to buy the spread because trader need to pay more to buy ATM options than he receives by selling OTM options.

Advantages of this spread is that the maximum loss the trader will suffer is cost of the spread i.e. amount paid to buy this spread plus brokerage & charges. Maximum profit is 100 points minus the cost. This combination offers other benefits by the way of drastically reduced theta decay and immunity form volatility swings even during current high volatile environment.

Vertical Spread that offers better theta decay and Vega metrics

Vertical spreads are directional strategies and they are just one strategy out of the many combinations that can be built by buying and selling options with different strikes.

Another popular strategy is volatility based strategies such as calendar spreads that gains when implied volatility raises or short strangles that gain from drop in implied volatility. Some other combinations such as iron condor is neutral strategy that are not affected much by implied volatility or directional moves.

One good thing about volatility based strategies is that implied volatility is reasonably predictable. For example an approaching result season or national election will increase the implied volatility that will again fall off after the event gets over

The disadvantage of spread trading is that it requires solid understanding of the option Greeks and knowledge on how will they behave in a given market scenario.

Its easier to start off with limited risk vertical spread and then move on to more complex unlimited risk combinations.

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