Options Trading

Mathematical Mistakes
‘Option Trading’

Shubham Agarwal, CMT, CFA, CQF, CFTe

CEO, Quantsapp
Content

Topics
• Objective of choosing Options over Futures

• Mistake 1: Holding Options Too Long

• Mistake 2: Buying Far OTM Options around Expiry

• Mistake 3: Buying Option ahead of Results/Events

• Mistake 4: Selling Options Early in Expiry

• Mistake 5: Strategy Creation

2
Section 1

Section 1 Choosing Options over Futures

3
A Trading System

A common trading system

4
Trading System

Strategy Backtest
Strike rate : 50%
Total Return : -2.2%
Max Drawdown : -18%

Call Option is what

you need

5
Market

Market Behavior

6
Market behavior

7
Option vs. Futures

Options over Futures

8
Linear vs. Non-linear

Long Future Payoff Long Option Pay-off

Unlimited Profit Unlimited Profit

Profit Profit

Call Option is what

Price you need Price
-tive +tive
Price Price
-tive +tive

Limited loss

Loss Unlimited loss Loss

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Enhanced Return

Trade on Nifty

Target: 100 points Stop Loss: 20 points

Case 1: Buy Futures Case 2: Buy Call Option

Target Profit: Rs.7,500 Target Profit: Rs.4,500

Call Option is what
Stop Loss: Rs.1,500 Stop Loss: Rs.1,500
you need
Margin: Rs.51,546 Margin: Rs.1,500

ROI: 14.5% ROI: 300%

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Reduced Losses

Trade on Nifty ( Gap Down)

Target: 100 points Desired Stop Loss: 20 points
Actual Stop Loss: 100 points
Case 1: Buy Futures Case 2: Buy Call Option

Target Profit : Rs.7,500 Target Profit : Rs.4,500

Desired Stop Loss : Rs.1,500 Desired Stop Loss : Rs.1,500

Call Option is what
Actual Stop Loss : Rs.7500 Actual Stop Loss you need
: Rs.1500

Initial Capital : Rs. 1 lac Initial Capital : Rs. 1 lac

Margin : Rs.51,546 Margin : Rs.1,500

ROI : -14.5% ROI : -100%

ROI(% Capital) : -7.5% ROI(% Capital) : -1.5%

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Types of Forecast

Types of Forecast
• Bullish – When instrument is expected to increase in
price.

• Bearish – When instrument is expected to decrease

in price.

• Eitherways (Volatile) – When volatility is expected in

either direction.

• Oscillate (Sideways) – When a range-bound

movement is expected.

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Flexibility

RBI Monetary Policy

Banknifty may go up 500 points if there is a 50bps rate cut

Banknifty should fall 500 points if rate cut does not happen

Call Option is what

you need

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…Flexibility

Trade on Banknifty Direction: Not Sure

If Up: 500 points If Down: 500 points

Case 1: Trade Futures Case 2: Trade Options

You can’t buy & sell the same instrument. Buy a Call & a Put
Call Option is what
Combined Premium: Rs.200
you need
Expected Movement: 500 points

Actual Movement: 400 points

Profit: Rs.200 (+ premium)

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Complexity

Complexity of Creating a Strategy

15
Strike Selection

Strategy: Long Call

Forecast
Instrument Nifty
Target 11300
Stop Loss 10800
Target Days 20

Which strike will yield the maximum ROI?

16
Which strike to choose?

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Multi-Leg

Why choose multi-leg Strategy?

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Multi-Leg Profits

Trade on Nifty Direction : Bullish

CMP: 11000 Expected Target :11300

Case 1: Buy Call 11000 @ Rs.150 Case 2: Trade Strategy

: Buy Call 11000 @ Rs.150
: Sell Call 11300 @ Rs.50

Target Achieved: Rs.11250 Target Achieved: Rs.15000

Payoff : ( 11300-11000-150)*75 Payoff 11000 Call:Call Option is what

(11300-11000-150)*75
you need
Payoff 11300 Call: (11300-11300+50)*75

Higher Profit

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Multi-Leg Losses

Trade on Nifty Direction : Bullish

CMP: 11000 Nifty falls to 10900 Expected Target :11300

Case 1: Buy Call 11000 @ Rs.150 Case 2: Trade Strategy

: Buy Call 11000 @ Rs.150
: Sell Call 11300 @ Rs.50

SL Hit : Rs.11250 SL Hit : Rs.7500

Payoff : (0-150)*75 Payoff 11000 Call:Call Option is what

(0-150)*75
you need
Payoff 11300 Call: (0+50)*75

Lower Loss

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Section 2

Section 2 Mistakes in Option Trading

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Mistake 1

Holding Options for Too Long

V

22
 Mistake 1

How much Quantity of Rice you’ll buy?

23
 Mistake 1

How much Quantity of Vegetables you’ll buy?

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 Mistake 1: Example

Holding Options Too Long

Forecast
Symbol Nifty
CMP 10957
Target 11200
Stop 10850
Reward / Risk 2.27
V
Long Call
Strike 11000 Strike 11100
CMP 105 CMP 66
IV 13% IV 12%
Days To Expiry 19 Days To Expiry 19
Forecast Evolves in Days 6 Forecast Evolves in Days 6
Price on Target 233.7966 Price on Target 161.8023
Price on Stop 45.04723 Price on Stop 22.60411
Reward / Risk 2.148302 Reward / Risk 2.207636
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Mistake 2

Buying Far OTM Options Around Expiry

V

26
 Mistake 2: Example

Buying Far OTM around Expiry

Forecast
Symbol Nifty
CMP 10957
Underlying Movement 10957
Movement in Points 0
Difference in ROI 45%
V
Long Call
Strike 11000 Strike 11200
CMP 47.34 CMP 3.95
IV 13% IV 12%
Days To Expiry 5 Days To Expiry 5

Forecast Evolves in Days 3 Forecast Evolves in Days 3

Price on Target 24.09033 Price on Target 0.216731

ROI -49% ROI -95%
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Mistake 3

Buying Options ahead of Results/Events

V

28
Mistake 3: Example

Buying Options Ahead of Result/Event

Forecast
Symbol IDFC
CMP 37.5
Target 40
Stop 36
Reward / Risk 1.67
Price after Result 39.00
% Move in Price V 4%

Long Call
Strike 38
CMP 1.48
IV 50%
Days To Expiry 19
Normal IV 25%
Call Price After Result 1.47
ROI -1%
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Mistake 4

Selling Options Early in Expiry

V

30
Mistake 4: Scenario 1

Selling Options Early in Expiry

Movement
Symbol Nifty Call ROI -57.8%
CMP 10957 Put ROI 45.7%
Underlying 11100 Net ROI -12.0%
Upper Range 11200
Lower Range 10800
V
Short Strangle
Days to Expiry 30 Days to Expiry 25
Call Strike 11200 Call Strike 11200
Call IV 12% Call IV 12%
Call CMP 60.44 Call CMP 95.35

Put Strike 10800 Put Strike 10800

Put IV 16% Put IV 16%
Put CMP 130.33 Put CMP 70.72

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Mistake 4: Scenario 2

Selling Options Early in Expiry

Movement
Symbol Nifty Call ROI -65.7%
CMP 10957 Put ROI 87.7%
Underlying 11100 Net ROI 22.0%
Upper Range 11200
Lower Range 10800
V
Short Strangle
Days to Expiry 10 Days to Expiry 5
Call Strike 11200 Call Strike 11200
Call IV 12% Call IV 12%
Call CMP 14.97 Call CMP 24.80

Put Strike 10800 Put Strike 10800

Put IV 16% Put IV 16%
Put CMP 53.09 Put CMP 6.53
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Mistake 5

Strategy Creation
V

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 Forecast

Let’s evaluate a Forecast

Instrument: NIFTY

Target: ?
V
Stop Loss: ?

Days: ?

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Forecast

Which Strategy to Execute?

V

35
 Forecast

Securitization

Strategy Evaluation Steps

Calculate the current IV

Calculate the Option Price forV the forecasted day

Calcualate the Option Price at Target & Stop

* Let’s try this using Option Calculator

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Strategies- Walk through
Bullish

(1) Long Call (2) Bull Call

Spread

(3) Ratio Call

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Strategies- Walk through
Bullish

Target comes in 3 days

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Strategies- Walk through
Bullish

Target comes in 3 days

39
Strategies- Walk through
Bullish

SL hit in 3 days

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Strategies- Walk through
Bullish

SL hit in 3 days

41
Strategies- Walk through
Bullish

Target comes in 6 days

42
Strategies- Walk through
Bullish

Target comes in 6 days

43
Strategies- Walk through
Bullish

SL hit in 6 days

44
Strategies- Walk through
Bullish

SL hit in 6 days

45
Strategies- Walk through
Bullish

Target comes on Expiry

46
Strategies- Walk through
Bullish

Target comes on Expiry

47
Strategies- Walk through
Bullish

SL hit on expiry

48
Strategies- Walk through
Bullish

SL hit on expiry

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Multi-Leg

Exercise with Multi-leg Strategy

V

50
Optimizer

Optimizer Algorithm
V

51
Combinations

Did you know??

Possible Combinations Approx. Scenarios

For Up to 2 Leg Strategy ~ 33,670

(For e.g. Spreads )

For Up to 4 Leg Strategy ~ 18,60,43,585

(For e.g. Condors)

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Complexity

Constraints

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Time Value

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Volatility

What if Volatility goes down by 25%?

What if it goes up by 25%?

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Other Constraints

Constraints
• Capital – The amount of investment in a
strategy. For options even the margin
system is non-linear.

• Risk – Maximum willingness of risk in a

strategy.

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Other Constraints

• Bid-Ask – The trades gets executed at

Bid-Ask which is wide at times. With
multi-leg strategies this is of utmost
importance.

• Boundaries – Strategies like Ratios,

Back-ratios can easily move to infinity
and boundaries are important.

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Data

Data – The Culprit

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Combinations

Trillions of combinations

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The Solution

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Optimizer Algorithm

The Optimizer Algorithm

 Prices Data
 Clean Greeks
 Forecast
 Capital
 Risk
 Vol Combinations
 Boundary Conditions
 Margining System
 Selection Mechanism

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How it works

Let’s take an example

Direction: Bullish
Instrument: Nifty
CMP: 10957
Target Price: 11100 (+243 pts.)
Stop Loss: 10850 (-107 pts.)
Target Date: 14-Feb-18
Reward / Risk: 2.27

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Summary

Summary
Options for enhancing Reward to Risk

Mistakes in Option Trading

 Holding Options for Too Long

 Buying Far OTM around Expiry

 Buying Options Ahead of Event/Result

 Selling Options Early in Expiry

Strategy Creation using Payoffs

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Thank You

64