Options trading: Use ratios to take away hurdles between you and the direction

Market

Shubham Agarwal
Quantsapp

We all know that options are one of the finest instruments to trade directions, thanks to their most liked feature of having a non-linear pay-off. You will always make more money from them when the move is favorable than you will lose when the move is unfavorable.

However, with that functionality comes a baggage -- the baggage that justifies the provision of such a favorable pay-off. This is essentially the known devils -- time, and expected volatility -- priced into the premium.

Often, these factors are to be blamed for a winning trade to turn into a less-than-winning trade or a losing trade.

Let us take both of them, one by one, and understand when these factors would hurt the most, and then discuss a remedy to the problem so that we can enjoy the benefits of options trading without the baggage.

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Time

The decay in time value is a menace like death and taxes, they say. Regardless of anything, option premium depreciates to a certain extent with time. We have learnt to live with it, but it becomes quite painful when this element takes the front seat.

The last 5-7 sessions of the expiry is when the time value decay is at its highest, and that is when the single options bought might actually be outdone in terms of stock price sensitivity by the time value decay.

To resolve this one may create a combination of a short option of a relatively higher call/relatively lower put. But considering the premiums,
it does not help much in funding the option buy. The better way to go is to create a ratio.

Build a ratio spread by buying a higher call/lower put relatively closer to the stock price, and shorting 2 lots of at least 2-3 steps, if not more, of even higher call/lower put.

What this would do is fund the option bought and let the trade live for the rest of the expiry. There is a hit that comes from 2 short options when the move is favorable but it does keep bothering less and less as we spend more time into the position.

Just in case this unlimited risk profile is not one’s style of trading, one can always go even higher call/lower put and balance the trade is a scary move is sensed.

Expected Volatility

This is one more pain point, especially on reversal moves, when a fall halts and an upward reversal starts the expected volatility would take a downward turn more often than not. This is natural as building something is always more time consuming than breaking.

In such a situation to save from the losses arising out of a drop in volatility especially when the trade is aimed at making the most of a move after a preliminary reversal move has already taken place, deploy a ratio spread.

Where the drop in expected volatility led premium loss would be more than compensated by the 2 shorts while the long option tries to make the most of the move.

Thus, ratios can help us get over the peculiar pain points of the options trading with a vigil deployment in aforementioned use cases.

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.