Sudden spikes force option sellers to tweak algos; traders add hedges, spreads, more to manage risk

Option spikes are sudden, and significant increases in the price of options often occur near their expiration date (zero days to expiry, or 0DTE). These spikes usually last for a few seconds but can trigger algo stop losses and disrupt trading strategies, especially those based on selling options. Experts say that these are caused by the activities of high-frequency trading (HFT) firms with significant capital, such as the US-based firm Jane Street.

Adapting strategies

In a conversation with Moneycontrol, traders shared insights into how they are combating these injections:

15-second sleep time

"I have added a 15-second sleep time. So in case of a spike, it won’t exit the trade; it will only exit the trade if the price sustains for more than 15 seconds, which indicates a genuine market move," said derivatives trader Rajesh Srivastava.

Reducing 0DTE trades, adding 1-3 DTE trades

"When the injections affected traders, the initial response was to cut down on positions and position sizing. Data shows that volumes and open interest in options have decreased. The so-called injections occur only at zero days to expiry (DTE), so strategies built for 1, 2, or 3 DTE are not affected," said Ashok Devanampriyam, CEO of Cautilya Stratazon Strategies.

Incorporating option buying and credit spread strategies into algorithms

Devanampriyam notes that his strategies were initially focused solely on option writing, so he was greatly affected by the injections. "However, we are now tweaking our algorithms to include components of option buying and spread strategies. We have reduced the option writing component in our algorithms and added 25-30 percent of option buying strategies and 20-25 percent of spread strategies. Consequently, our algorithms now allocate 25 percent each to 0 DTE and 1-3 DTE strategies, option buying, and spread strategies," he said.

According to Devanampriyam, the injections are like tsunamis; they cannot be predicted or tracked in advance. "We will keep ‘buy’ strategies active every day, but they need to be mature, sensible strategies to fight theta decay and capitalise on the injections on specific days. Option spread strategies help in keeping risk and reward defined and facilitate making small, regular, stable profits," he explained further.

Challenges and observations

The spikes are now occurring as frequently as four to five times a month, compared to perhaps once a year previously, posing significant challenges for traders. The phenomenon was initially observed in less liquid expiry counters like Midcap Nifty and Finnifty.

However, on May 16, even the major index Nifty 50 was caught off guard, gaining nearly 340 points in the last hour of trading. Option writers were caught off guard as Nifty saw a Rs 150 upswing in in-the-money calls, which were expected to expire worthless, triggering stop losses. Meanwhile, call option buyers profited significantly from the popular "hero or zero" trades on expiry day.

The ‘zero or hero’ option trading strategy focuses on capitalising on sudden price movements that occur near options’ expiration.

Disclaimer: The views and investment tips expressed by investment experts on Moneycontrol.com are their own and not those of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.