Expiry trading is highly attractive to a majority of Options Traders where buyers are hunting for last moment large surges for a high return on investment whereas on the other side Option Writers are busy analysing levels beyond which the index or the stock might not expire to earn small absolute premiums of the OTM options.
But, the base of all is at which point expiry will happen?
Well, there isn’t a way to exactly forecast the level precisely to my knowledge but there are several add-on indicators traders used to gauge the possible level of expiry two of them being recent Value Weighted Average Price (VWAP) of the underlying and Option Pain level derived from Open Interest and Intrinsic value of options for possible expiry levels.
If a trader is able to successfully forecast the level; or a narrow range of expiry, there exists several strategies which can be of high yield namely: Short Straddle, Short Strangle or a hedged strategy with a high reward to risk ratio along-with limited risk i.e. Butterflies.
Let’s learn both the methods for creating a forecast for expiry.
Value Weighted Average Price of the recent past for the underlying instrument can suggest an average price where buyers and sellers form equilibrium and hence, the level is expected to form an approximation for expiry.
However, there is no thumb rule of what time period should be considered as an input to this calculation. But, a more sensible way out would be to calculate VWAP’s from significant recent swing movements of peaks and troughs.
Option pain is a calculation to find a level at which Option buyers will have a maximum loss and as derivative is a Zero-sum game, it means Options Sellers will make maximum profits or least losses at this point.
The pain level is calculated by multiplying the Open Interest with the intrinsic value of options for different levels of expiries for each strike. The pain line is derived by adding the Call P&L along-with the Put P&L at each strike.
The level which comes as the maximum profit or lowest loss is the level of Option Pain.
The reasoning behind tracking the pain level is first, Option writers are expected to be the smart money around as they take the unlimited risk for a very little profit so they tend to have a well-researched approach.
Secondly, option writers adjust positions with their revised forecasts of the market and the market as a whole tends to that equilibrium.
Option Pain is not a complete calculation as the formula doesn’t account for the premium inflow that the Option writers already received and even though some strikes might show losses where the Option writers may have made significant returns from premium erosion.
Similarly, few strikes may have been under-estimated too. A better approach would be to adjust for the premium received but is certainly a difficult task to perform as trades takes place on a continuous basis and the price is certainly not constant.
High Probability Areas:
Option Pain in our study has been mildly accurate if used raw but a filtration from other technical analysis or derivative analysis tools to decode if the underlying is in a trend or oscillation can help raise the odds of the forecast being right.
Pain level will be respected more in an oscillating market rather than in a market which has a very sharp trend. Lastly, Indices are much more stable for this tool over stocks.Disclaimer
: The author is CEO & Head of Research at Quantsapp Private Limited. The views and investment tips expressed by investment expert on moneycontrol.com are his own and not that of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.