Option trading lessons from the man who sold his trading system to JPMorgan

In Nandy, one’s search for a successful trader who is an option buyer ends. He picks his trades using his proprietary indicators just before the stocks spurt thus making option buying a successful strategy. His life demonstrates how grit, hard work, knowledge and discipline can help a trader achieve financial freedom. The man battled depression after his mother’s demise and came up trumps from an over-trading-induced financial ruin.

Between playing the markets and long breaks, Nandy pursues many things. He is a voracious reader, a movie lover and a trainer. He says he seeks ways to improve his trading and is learning data science and software languages like Python to better his approach to the markets.

In an interview to Moneycontrol, Nandy speaks passionately about his journey and approach to trading. Excerpts:

Q: Could you walk us through your journey to the market?

A: I was always an average student during my school days in Kolkata… not too bad, but also not that good. I was interested in reading things beyond the subjects taught in school. I took up economics as main subject, math and statistics in part during graduation. I did not understand the applications of the subjects taught to us then, but after joining the market, I bought and studied from the books on statistics and finally understood what was being taught.

My entry in to markets was rather accidental. My father died when I was 11 years old. When I was 18, my mother said suggested buying a flat for which she took a loan from LIC. Also, we sold a parcel of land and managed to raise enough money for the flat.

When my mother looked at paying off the Rs 50,000 loan, Sushil Periwal, a student of hers and a sub-broker, told her invest the sum in the market instead. Periwal bought us some good shares like Brooke Bond, ITC, Shaw Wallace – all dividend-paying companies that announced regular bonuses.

This was 1991 when the Sensex was 1200. I know this because when I became an analyst I checked on the market level at which we entered.

The year 1991 was also when I completed my higher secondary. In those days in Bengal, the trend was that a young person would learn typing and shorthand the moment they passed higher secondary so that they can at least secure a sarkari job as a stenographer. A job in markets in a Bengali household was akin to gambling. I was not interested in going the traditional way.

One day, I accidentally bumped into the broker who bought us the shares. He asked me if I had interest elsewhere. I told him that I had no interest in being a steno and he asked me to come with him to the Kolkata Stock Exchange the next day. Those were the days of open outcry and I was hooked the moment I stepped in.

I read up on a few books on fundamental analysis and started dabbling in the markets. This was the Harshad Mehta boom period and I was buying shares at around Rs 16 and selling them at around Rs 80. I bought Master Shares in their issue at Rs 10 and sold it at Rs 80 in the curb market. I was in my first year of economics honours and felt like a god. The Rs 50,000 that was first invested touched around Rs 3.5-4 lakh.

What happened next was pure luck, though that is not how I saw it then. The flat that we bought was not in a good locality and my mother was insisting that we buy a house. She asked me to sell all the shares and buy the house. I cried telling her not to do so. As providence would have it we got an offer for a house. I sold the shares reluctantly and bought the house. I did not speak to my mother for a few days after that.

The best part is that within 15 days of buying the house the market collapsed and I was back studying economics.

Q: What did you do after the crash, in terms of career and market experience?

A: I used the market crash to read a lot of books on markets. I came across Benjamin Graham and heard about Warren Buffett during this time. Most of my studies were related to fundamentals rather than technical analysis.

After my graduation, I worked at various companies, used the time to complete a part-time MBA course in marketing. I took a break in my career to study for government jobs and managed to crack the LIC Development Officer exam.

But all throughout, markets were always a part of the daily chore. While working for LIC, I used to place my orders with the broker and then head to an office.

Before 1999, I used to trade the markets based on news, market information and similar stuff. Post-1999, I learned technical analysis and managed my trades based on it.

I was doing well in those days. My job was paying me Rs 11,000 a month while my average earning from the market for a period of 8-9 months was around Rs 32,000 per month. At this point, I felt that I could become a trader. I had moved from fundamentals to technical post the 2000 crash.

I then decided to take a sabbatical from my job and give trading a shot for a year. My trades were good, I was trading in futures contract and by the end of the year I quit my job and traded fulltime.

Life was good and then 2003 happened.

Circa April 2003, I was trading futures contract and made decent money. On April 10, 2003, Infosys announced a lower than expected guidance and its price fell from Rs 4,200 a share to Rs 3,060 a share in a day.

I knew that with this kind of selloff the Relative Strength Index (RSI) would be in the extremely oversold range. Now I had done these kinds of trades earlier where I went long on an oversold position and did well the next day. My line of thinking was that the company had only lowered its guidance but there is nothing wrong with this great company and the price would bounce back.

I went long four contracts by the close of the market at around Rs 3,060. Next morning as the market opened I was standing right behind the dealer eager to book my profit.

The first tick on the market was a rate of Rs 2,880. I did not freeze when I saw the price. I knew I was wrong in my analysis and asked the dealer to sell 8 contracts which would mean I would cover my 4 long contracts and would be short on four contracts.

The next quote on the screen was Rs 2,740 I moved my order to this level but did not get a fill. Next tick 2,600 and then 2,580 then 2,400 and 2,240 all without my order getting executed. At this point, I told my dealer to sell 8 contracts on the market rather than a price point which would ensure a fill.

I managed to book the loss on my long position of around Rs 3,060 at around 2,240 and go short at the same level.

Infosys closed the day at around Rs 2,880. I was a wreck. Not only did I blow my account but now I owed the broker Rs 50,000 and I did not have any source of earning to repay this money.

It was not the money that was playing on my mind, it was the burden of going back to my sales job pleading people to buy stuff and watch my boss throw tantrums. I was too used to the freedom I enjoyed over the last three years and dreaded the thought of losing it.

Q: How did you come back?

A: The first thing I did was to tell my mother what happened. She had by now retired and we now had only her retirement savings with us. I informed her that I might have to take up a job again but said I will take some time before taking one.

For the next one month, I was in front of the computer for nearly 18-19 hours every day. The thought that was plaguing my mind was why did no technical system that I knew could predict the fall. Either the subject of technical analysis was all bunkum or there is something that I might have overlooked. I was searching for any form of price analysis or any indicator that could have predicted the fall.

After a month, I found what I was looking for. Rather than looking at trends and momentum which most technical analysts do I found my answer in volatility. Unknown to me I was studying VIX (volatility index). I made my own indicator which on back-test predicted the fall in Infosys. (The recent fall in markets was also tweeted by Subhadip before it happened using more or less the same indicator).

Now that I had an indicator, the next thing I needed was funds to start. An uncle of mine had recently taken voluntary retirement from his work and asked me where to invest. I had asked him to pick up HPCL at Rs 130. He picked up Rs 5 lakh worth of shares of HPCL. I thought of approaching him. Instead of asking for money I asked him to lend me 100 shares of HPCL which I will use as margin. He refused to do so. That was one more learning that market taught me.

My broker called me and asked me to start trading. He said that he would give me a leg room of Rs 10,000-15,000. If I lose this money I would have to stop trading. This was the same broker whom I owed Rs 50,000.

That’s how I started trading again.

Q: Now that you had a method to your trading, how did you do?

A: I decided on a more focused approach, the stock I picked was ACC. I traded it on an intra-day basis or short-term positional basis. During this time the one thought that I had was that my fund size was Rs 10,000 and I have to manage my trades within this limit. That is how I learned about risk management.

To this day, I stress more on risk management than on simple buy and sell points. Within a month, I increased my account size from Rs 10,000 to Rs 50,000. I paid back Rs 25,000 to the broker and took a cab back home.

I told my mother about my performance and asked her if she was willing to back me. A Rs 60,000 LIC policy of my mother had just matured, she gave me the entire amount. Since, that day I have never looked back.

Q: You were also on the board of a market-related software company, how did that happen?

A: I decided to automate the strategy that I had prepared. One day my data vendor saw what I was doing and asked me if I was willing to sell it. I felt that there would be no interest in the market for such a product, but he was confident. After a few sales, we landed in JP Morgan’s office for a presentation. We managed to sell the system for Rs 2.5 lakh and used that as our selling card to other people.

I was then approached by a Kolkata-based proprietary trading firm in 2008 to head their 200 member trading team. We traded instruments across asset class there. This was systemic trading and we leased some automated software by paying a lot of amounts. My managing director then told me if it could be developed in-house and I responded in affirmative.

We formed a software company in Delhi where another person from Microsoft joined us and our MD was the financier. We developed trading software and ran it profitably on commodity exchanges. We were one of the first firms to run the automated system on the commodity exchanges. At this time, I was also trading for the firm. We were hedging currencies for three corporates at the time.

Q: How did you end up being a prop trader then?

A: It was in 2013. I was working in Delhi in the software firm and had to come to Kolkata as mother was sick. We found out she was suffering from blood cancer. Within a week she passed away.

I was completely in shock. A year ago, I lost a very close school friend to cancer and now my mother who meant the world to me. I did not know why I was working the way I was. I told my boss I was quitting the job. My wife told me to take as long a break as I wanted.

In the next six months, when I tried opening the terminal to trade something weird was happening. Till then I was comfortable trading a currency position of $10-20 million, but now when I was trading even one lot of Nifty and if the position went against me by 4 points my heartbeat was increasing. I just could not do what I thought I was good at. Most of the trades over the next six months were loss-making.

We decided to take psychiatric help. I was told what was happening to me was a fear of loss, not only monetary but about other things. Slowly with psychiatric help, I was able to make a comeback and by early January 2014, I was trading again but only on my own account and that too only in Nifty.

Q: How do you trade now?

A: I have a more refined system of trading now than what I was trading earlier. Now, I trade mostly in options. The Infosys incident taught me was that options are the only instrument that can prevent you from a Black Swan event.

My trades nowadays are mostly option spreads. Though I trade directional, I trade it through options. The Adani trade that I am carrying now (discussed at length by Subhadip on his Twitter handle) is a 175-180 bull spread (buying 175 call option and selling 180 calls) where the maximum risk I am carrying is Rs 1. So a 4,000-share contract on my five lot position would mean a risk of Rs 20,000 and the gain if the price touches Rs 180 is Rs 80,000. Adani came to my notice from Rs 140 levels. But all throughout I was not worried even if the stock crashes by 20 percent or more as I had the protection of a spread position.

The key is how to identify stocks that give these moves, that is the learning from the Infosys trade. When a stock falls from that level all trend following and momentum indicators will inform you after the event has happened. These are lag indicators.

My discovery was volatility indicators, that too short-term indicator.

Say Infosys is moving in a range of Rs 10 on an hourly bar for the last 8-10 bars but suddenly there is a Rs 20 fall. This will not be captured in the end-of-the-day bar as the price moves by say Rs 40 in a day. But the Rs 20 fall in a single bar when the market was moving in a Rs 10 range for nearly 10 hours alerts me that the tides may be changing. This move gets first captured by volatility rather than trend and momentum.

What I have done is create my own volatility indicator which I monitor regularly for stocks as well as indices that forewarns me about the shifting volatility.

I also mix the volatility indicator with other data from derivatives which give much more information than data from the cash market. The cash market gives the open, high, low and closes along with volume and deliveries. But derivatives gives open interest as well as the entire action of an option chain which help in a more meaningful analysis of the counter.

Now volatility is a price-based indicator while a volume based indicator is an open interest. Majority of my price based study is on volatility and which side will the price break and if it is supported by open interest.

My hunting ground is stocks that are in the low volatility zone from where the stock will make a fresh move. As I am an option buyer and a directional player what I am looking for is a compression in volatility before the stock moves up with expanding volatility one last time.

Volatility has three characteristics they are – cyclicity, persistency and mean reversion. Cyclicity suggests that volatility will move from a high zone to a low one and again from low to high. Persistency says that if the volatility is high today it will again be high tomorrow or if it is low today it will be low again tomorrow. Mean reversion says that volatility will snap back from a high volatility zone to a low one and vice versa.

Now suppose you have a stock that is in the low volatility zone you have two characteristics in your favour. One is that cyclicity will ensure that volatility will move from the low to high zone while mean reversion will also suggest that the volatility will snap back to the mean. All you have to look out for is a breakout in volatility and if that breakout is followed by open interest going up then you are in a very good trade.

This way of trading is good for trading in stock options rather than index options. In index options, the data gets corrupted by varies strategies that FIIs use like synthetic futures (long calls and short put) that one filter out from the open interest data.

My list of stocks is restricted to 10 stocks where the options are liquid, where FIIs are active and it has a long option chain. I am more interested in trading a stock that is moving slowly rather than one that moves 20 percent in a day. I will trade this stock more from a day trading perspective.

Q: Could you share your track record in trading?

A: I trade two strategies. One is a simple bull or bear spread. Here I look to trade with a risk reward of 1:4. What I mean by this is that if there is a Rs 10 difference between two strikes, my spread cost (cost of buying an at-the-money option minus credit from selling out-of-the-money option) will not be more than Rs 2.5.

The risk-reward increases as we near expiry. The Adani spread trade of Rs 170-180, when I entered was at Rs 1 which moved up to Rs 4.5. If the above trade touches Rs 180 I will earn Rs 9 for every Rs 1 risked. But I do not play for the Rs 9. As soon as the spread increases to Rs 2, I square off half my position. When it reaches three times the risk I square off another 25 percent and it is only the last one that I wait for the entire length.

So in this strategy, I do not have to be correct all the time, even if I am right 35 percent of the time I am not losing money. But generally, I am correct over 50 percent of the time.

The other strategy I trade is the profit trap butterfly. This I trade closer to the expiry, actually expiry minus 13 days. Here I try to make an assumption of where the stock will close at expiry. I did this in HDFC Bank a few months back.

My assumption was that the stock would close at Rs 2,200 so I created a short butterfly (selling both calls and put) at 2,200 strikes I then bought 2180 put and a 2220 call. Here the difference in strike price is Rs 20. I take this trade if the risk-reward is 15 percent or less. That means, in this case, the spread for a Rs 20 difference in strike price should be a maximum of Rs 3. I managed to enter the trade at a spread of Rs 2. Here if the profit is Rs 4 I will book 50 percent of the profit.

I also trade intra-day but this is an automated trade where I enter the order if my system tells me. I have a nearly 60 percent success rate in intra-day trades with a risk reward of around 1:2 or 1:2.5.

Having said that there is another filter of risk management that I use. I have a daily, weekly and monthly target for risk as well as reward. I do not take a trade that does not come to me.

I also make it a point of taking a break every month and a half, especially if I am trading too well or have hit a bad patch. The trips help me get back on track from the emotional swings.