Option writing in consolidating markets: Shubham Agarwal

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Nifty has been consolidating within a couple of percent range for last 5-6 weeks. These are ideal markets for Option Writing (Selling). Option Selling helps when the passing time reduces premium of Options at the same time no directional move does not push the Option premium higher.

However, what looks very easy at this point in time would not have been so easy while going through consolidation. The halt in momentum is easy to see in past tense. However, it is not as difficult either.

The very nature of consolidation is that it is very contagious in nature. Once started it continues for some time.

This very characteristic gives the chance to Option writing opportunities. Before we jump into that let us revisit a few things.

What are the characteristics of consolidation to account for by the Option Writer?

1. Consolidation comes with limited directional movement helping the Option Writer. However, it is open secret. Because of this we will have relatively lower premiums as well.

2. Consolidation does not mean absolutely no movement, there will be a movement but in range such that a series of ups and downs do not take you anywhere.

3. Consolidation also has an expiry and that expiry comes with a bang. Range break after a consolidation often comes with a big move after that.

We need a trading strategy that takes care of all these 3 conditions. History has it that on average more than 6 out of every 10 options created have turned to 0 at the end of expiry. So, not being successful in this trade is not a concern. Biggest concern is that largest losses in Options are incurred in the history also by Option writers.

Let us start with the 1st problem of lower premium while writing options in consolidation. On average the premium drop that happens due to time is higher in strikes closer to the current market price. So, the best way to beat the relatively lower premiums by writing options close to the current market price. This does beat the problem of lower premium but raises another problem of losses in the trade.

The 2nd problem becomes more evident now because now even smaller movement will hurt the profit. This can be defeated by selling 2 Options, one of each kind. Sell a Call and a Put option. So, in case of a rise Call Sell is losing money but a part of that loss is being compensated by Put Option Sell which will fall with the rise.

However, 3rd problem still remains open because losses in one Option sell is unlimited but the profit from the compensating sell in another Option is limited. To safeguard this, buy 2-4 steps higher strike Call for a Call sold and 2-4 steps lower strike Put for a Put sold closer to the current market price.

This will not only safeguard from any accidents but also reduce the margin. Hence, the return on investment also improves.

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