Favourable option strategies

In my youth, I spent a lot of time on racecourses, because I liked horses and gambling. One of my race-acquaintances was a retired professor of mathematics who consistently turned a profit on very modest bets.

He explained his “system”. Prof, as I called him, had figured out what he called “a favourable odds range”. That is, suppose there are 100 races held every year in Kolkata during the monsoons. In 40 of those, the winning horses were available at odds of even money or thereabouts, while 20 horses won at odds of between 3-1 and 5-1 and 10 horses won at odds of between 12-1 and 15-1, and 7 horses that won at odds of above 25-1, etc. betting on every favourite meant losing money – the return is about Rs 40 for every Rs 60 lost. If you bet selectively on horses in the 3-1 and 5-1 range, you may come close to break even.

But if you bet on the right horses at odds of between 12-1 and 15-1, you may make money. The return per win multiplied by the number of wins is greater at that odds range, than the losses incurred on the horses that lose. The punter could win Rs 120 or more on 10 winning bets, while losing Rs 90 on 90 losing bets. That is what the Prof called a favourable odds range.

The prof had worked out favourable odd ranges for every season across races at Calcutta, Bangalore, Bombay and Madras (as those places were then known). Of course, he was also good at selecting possible winners in favourable odds ranges. And, he had the discipline required not to bet if he thought the odds were adverse, even when he was “dead-certain” of winning.

Similar thinking applies to a lot of trading strategies. It is sensible to make a certain kind of bet, which will not work very often because the odds are favourable. It is not sensible to make another bet even if it likely to work often because the odds are against.

One classic situation where traders mis-diagnose the favourable versus unfavourable are wide option strategies. If you study option pricing, you will notice several interesting repeating patterns.

One is that premiums for far from money (FFM) options fall sharply around the settlement period, as the mid-month series becomes the near-month series.

For example, the December Nifty 7000c is very likely to drop in price in the 3-4 session period of November 27- December 2, as November expires and December becomes the near-month series. Second, you will notice that FFM options at say, 10% distance rarely get hit at all.

Is it possible to exploit these situations by selling FFM options? Option selling is dangerous. The potential loss is unlimited. The seller must put down margin money and he could suffer a large loss.

The first pattern – the 3-4 session premium drop may be exploited by selling FFM options on November 27 and buying back on December 2. It may be also be possible to sell FFM options and wait for the positions to expire without buy back, garnering larger gains.

The first trade has favourable odds. Chances are very low that the market will swing enough in a given period of 4 sessions to run at a loss. The second trade is losing. The market rarely swings 10% in a month but it swings 10% often enough to generate losses in the long run.
The author is a technical and a equity analyst