Option trading strategies

Just after a derivatives settlement, there are option pricing imperfections. The market has a tendency to price unlikely events cheaper than justified. For example, as a new settlement begins, you can buy cheap Nifty options at a distance of, say, 10 per cent from money. If the market moves 10 per cent in the settlement, those options become multi-baggers.

History suggests this kind of swing happens often enough to give a handsome profit over say, two years. The psychological barrier is that the trader loses relatively small sums most of the time, since the distant options expire worthless if there isn’t a big swing in the settlement. But he makes an occasional huge gain.

A variation is to implement this strategy with calendar spreads. For example, if you buy a distant April option, you can also sell a May option at the same strike.

This reduces the net price at the least and may bring some net inflow - the May option is usually more expensive. If both options are struck, gains on the April position offset May losses. Otherwise, if April expires without a strike, the May short option can be extinguished.

The inverse calendar spread of short April option and long May option with the same strikes reduces the net cost of a long May position. This is a good strategy if you want exposure to a distant strike over a longer time-period. Again, if both options are struck, they will offset each other. Otherwise, once April expires, you are left holding a long May position at low cost.

Another effect to be noted at settlement is a drop in closer-to-money premiums. For example, April 2012 Nifty options will be expensive until the settlement day (March 29). In the first two or three sessions of the new settlement, April premium pricing will normalise. Close to money premiums will often drop as the reduced time to expiry is priced in.

One possible arbitrage is by selling April options very early in the settlement and buying them back in the next two or three sessions. If the naked short option is struck, of course, you lose a lot of money.

But you are betting there won’t be a big swing in the two or three sessions you hold the short exposure.

This is the opposite of the first strategy. Most of the time, you’ll make a little money by selling options at some distance from money. This strategy seems to work better with options priced at around three to six per cent away from money, rather than at 10 per cent distance.

The author is a technical and equity analyst