SELLING OPTIONS

MK

WHY SELLING IS BETTER ?

 Most options, held to expiration, expire worthless  Options are a wasting asset  It takes a larger move in the underlying futures or shares for the option to be more worthy to the buyer.  The closer an option is to expiration, the more difficult it becomes for that option to increase in price and produce profit for the buyer.  Projecting where the market will go is more difficult than projecting where the market will not go.

Why selling is better ?

 The trend is your friend.  Write the options that favor the trend and you could boost your odds substantially that the options will expire worthless (i.e., sell put options in a bear market and call options in a bull market).  Option sellers still come out ahead when they are going against the trend (i.e., even in bull markets most calls expired worthless and in bear markets most puts expired worthless).  An option buyer is working against the market and time and for the option seller passage of time is a great ally.

Criteria
 Low Delta (< 0.2) & High Volatility :  High Delta (>0.7) & Low Volatility :

Sell Options Buy Options

 Options with low historical volatility often can be an indicator that prices in the underlying futures contract are very calm or trading in a narrow range. It can also be an indicator that a market is ready to break out of trading range and make a sizable move in one direction.

Volatility
 Volatility is a statistical measure of how erratic a stock has been in the past, and how erratic its expected to be in the future.  There are two types of volatility as it applies to options trading:
 Historical Volatility (HV) measures how volatile or erratic the stock or commodity has been in the past.  Implied Volatility (IV) measures how volatile or erratic the stock or commodity is expected to be in the future

 HV is backward-looking whereas IV is forward looking and considers all the developments expected in future.

Volatility
 Buy options when IV is low and sell when IV is high  Everything else being equal, an option with higher volatility (and hence higher price) may result in higher profits in the short-term.  Importance of volatility before major events :
 In the days leading up to any major event, implied volatility is increased thereby increasing the option price.  When the event finally takes place, even if the share price goes up, the option price may not go up or even go down since the IV is restated to lower levels after the event.

Volatility Skew
 This is a phenomenon where each individual option within an option chain will have its own volatility value, which may or may not be different from its neighbouring option.  Volatility skews can take the shape of a reverse, fl at, smiling, or forward pattern, and can be used to your advantage when initiating option spreads.

Volatility Index
 Indicates the expected market volatility over the next 30 calendar days  Higher the implied volatility higher the India VIX value  Low VIX
 Market is range bound or has a mild upside bias  Call option buying generally outnumbers put option buying

OPEN INTEREST
Price Open Interest Interpretation

Rising

Rising

Market is Strong

Rising

Falling

Market is Weakening

Falling

Rising

Market is Weak

Falling

Falling

Market is Strengthening

Option Pricing
 There are six determinants to a stock options price:
 1. Price of the underlying stock.  2. Strike price of the option.  3. Time to expiration.  4. Volatility.  5. Interest rates.  6. Dividends.

Put / Call Ratio

 Put call ratio is computed in 3 ways :
1) Sum of all put options open interest divided by sum of call options open interest at various strike prices on same maturity date 2) Price of these options are multiplied with volumes in (1) above 3) Volume of put options divided by volume of call options

Two types of put call ratio :

Equity Put Call Ratio

Total Equity PCR Individual Equity PCR

Index Put Call Ratio

Dos and Donts

 Dont enter the market in a hurry w/o watching its direction for the day (Wait for S+30 to place your orders)  Dont accumulate a falling stock and multiply your losses  Dont invest more than 25% of your money in one option  Enter the market with a clear target to come out normally @ 50% of your daily targeted gains  Come out after losing 10% of your kitty or 2 days of investment whichever is earlier  Avoid over-leveraging : dont invest more than 75% of your kitty on any day  Go for low-risk options once the weekly target is reached

Dos and Donts

 Watch key events of the next 3 days before you invest  Stay away from market on the days when events or announcements are expected  Avoid stocks with uncertain news outcome  Look for other indicators before investing :
 Open interest and changes in it  PC ratio  Volatility index

 Buy options only if

 Delta > 0.68 (or -0.68) and  Volatility < 55%

MACD

MACD (Moving Average Convergence Divergence)

 Moving Average Convergence Divergence (MACD)
 MACD is a trending market indicator (Dont make the mistake of using MACD in all types of market conditions)  MACD needs to be used after confirming the trend with ADX  The MACD is calculated by subtracting the 26-day exponential moving average (EMA) from the 12-day EMA.  A nine-day EMA of the MACD, called the "signal line", is then plotted on top of the MACD, functioning as a trigger for buy and sell signals.

MACD
 Trading Rules
 Go long when MACD line (shorter term MA) moves above the signal line (longer term MA) i.e., +ve histogram  Go short when MACD moves below the signal line i.e, -ve histogram  Wait for a confirmed cross above the signal line before entering into a position to avoid getting "faked out. Apply a price filter (e.g. buy if MACD breaks above the 9-day EMA and remains above for three days)

 A rising MACD shows the bulls are becoming stronger  When the security price diverges from the MACD. It signals the end of the current trend.  When the MACD rises dramatically, it is a signal that the security is overbought and will soon return to normal levels.  A Positive Divergence occurs when MACD begins to advance and the security is still in a downtrend and makes a lower reaction low. This is the most reliable indicator.

Selling Options Trading Rules

 Dont develop a cant lose mentality after initial success and dont invest more than 70% of your money at any point of time. Keep the remaining amount as back-up.  Decide on stop loss levels and exit levels before you enter.  A market doesnt have to have a trend for you to sell options in it. But, if there is a trend, it is best to sell your options in favour of it.  Dont become emotionally attached or averse to the market.  Avoid taking biased decisions based on past experiences  Keep an open mind and approach each trade as a brand new opportunity, independent of past profits or losses.  Dont let your emotions get in the way of opportunities for you. Accept that no market is good or bad. Only your position is good or bad.  Buying options on a market because something might happen is outright gambling.

Selling Options Trading Rules

 Instead of trading every day or every week in 10 different markets, only trade when you believe there is a stellar opportunity to sell premium, and then dont be afraid to build a healthy position there.  If youre bullish on a market, sell puts. If youre bearish, sell calls.  Use a combination of fundamental and seasonal analysis, and look at general price direction over a two- to six-month period.  Try to select price levels that could only be achieved through a radical change in fundamentals.  Having an excellent risk-management plan is the key to consistent profits.  If you are selling far-out-of-the-money options, the option value generally will increase very slowly, even if the market is moving against you.

Selling Options Risk Management

 200% Rule :
 Exit the option if premium value goes up by 100%