Today we’re not just delving into the world of option trading; consider it a comprehensive workshop. We’ll be exploring the art of option selling, a topic often overshadowed by its buying counterpart. Joining us is Mr. Shubham Agrawal, an esteemed professional with extensive expertise in the field. As the founder of his own company, Mr. Shubham has been instrumental in guiding individuals through the complexities of options trading.

In lastly, we touched upon the relative performance graph and strategies for option trading. If you missed that, find the link at the end of this post. Today, our focus shifts to option selling, a strategy that demands precision and understanding of market trends.

Many traders identify themselves as either option buyers or sellers, adopting a rigid stance. However, we propose an opportunistic approach. Recognize the opportune moments for both buying and selling. Mr. Shubham, a seasoned trader himself, advocates for this flexible strategy, having successfully managed substantial portfolios.

Let’s start by understanding when to initiate option selling. One fundamental principle revolves around market movement, specifically identifying whether the market is trending or ranging. A widely-used indicator for this purpose is the Average Directional Index (ADX). When ADX is below 25, it indicates a sideways market, creating an opportune environment for non-directional strategies.

It’s crucial to be an opportunist rather than limiting oneself to a specific role as an option buyer or seller. Market dynamics change, and a versatile trader can adapt their strategy accordingly. Mr. Shubham emphasizes the need to align strategies with market trends, fostering a higher probability of success.

Moreover, the ADX serves as a key tool for assessing market trends. If ADX rises above 25, indicating a trending market, it suggests an adjustment in strategy. While a non-directional approach is suitable for a sideways market, a directional strategy becomes more viable when ADX is above 25.

Now, let’s discuss the concept of implied volatility and its role in option selling. Implied volatility reflects the market’s anticipation of future price fluctuations until the option’s expiry. This expectation often deviates from reality, introducing an element of uncertainty.

To gauge the potential success of an option-selling strategy, traders should consider the interplay between implied and future realized volatility. Historical volatility provides insight into past price movements, while implied volatility forecasts future fluctuations. The ultimate challenge lies in predicting how closely implied volatility aligns with future realized volatility.

Adjustments play a crucial role in navigating option-selling strategies. When a trader finds themselves in a losing position due to a shift in market dynamics, timely adjustments become imperative. These adjustments may involve reallocation of funds, including a mix of buying and selling strategies to mitigate losses and maximize profits.

In the realm of trading, understanding implied volatility (IV) becomes pivotal. It represents the market’s expectation regarding future price movements. Much like selling a valuable possession at a prevailing market price, when selling options, one engages with implied volatility. But what if you wish to sell at a different price than the current market IV? This dilemma forms the crux of today’s discussion.

Let’s consider a practical scenario. You visit a market to sell gold. The prevailing market price for gold is Rs. 65,000. That’s the rate at which your precious item will be sold. Similarly, implied volatility is a price, as seen in the India VIX chart. If you want to sell IV at a particular level, say 20, but the current market IV is 15, how do you bridge this gap?

The challenge arises from the fact that you can’t sell at your desired IV if the market IV is lower. In trading terms, this means you might want to sell at a higher IV, but the current market conditions don’t allow it. This situation prompts the question: how can you sell at a different, higher IV?

To shed light on this, let’s consider a practical example involving the Average Directional Index (ADX). When ADX is above 25, it indicates a trending market, and IV is likely to increase. This rise in IV becomes an opportunity for the option seller. By identifying favorable conditions, one can potentially sell options at a higher IV, aligning with their desired price.

In a conversation with Mr. Shubham Agrawal, a seasoned professional who has successfully managed substantial portfolios, a crucial insight was revealed. In the past, he and his colleagues engaged in selling entire option chains, significantly impacting market open interest. During this period, the average annualized Compound Annual Growth Rate (CAGR) stood at an impressive 42%.

Now, let’s delve into the dynamics of implied volatility and future realized volatility (FRV). Implied volatility is what traders sell when engaging in option selling. On the other hand, they buy FRV, representing future expectations of volatility. If a trader wants to sell at a higher IV than the current market level, they must wait for conditions that will likely lead to an increase in IV.

To calculate the expected market movement based on IV, a simple formula is applied. By multiplying the IV by the square root of 1 divided by the number of trading days in a year, traders can determine the expected percentage movement. This insight is crucial for decision-making when it comes to selling options.

The foundation of option selling lies in forecasting market movements. By understanding the expected percentage movement based on IV, traders can make informed decisions. If the anticipated movement is less than what the market expects, it becomes an opportune time for selling options.

Navigating the intricacies of options trading involves understanding the interplay between implied volatility (IV) and future realized volatility (FRV). The nuances become apparent when the market conditions don’t align with the desired IV for selling options. So, when does IV matter the most, and how can one profitably engage in option selling?

Foremost, let’s acknowledge the game-changing aspect of implied volatility. The fluctuation in IV becomes a pivotal factor in options trading. The challenge emerges when traders aim to sell options at a higher IV than the prevailing market conditions allow. This prompts the need for forecasting – understanding when IV is likely to be higher or lower.

In the realm of IV, there are distinct regimes. To illustrate, an IV above 15 or 16 is generally deemed favorable for sellers. The belief is that higher IV leads to a more lucrative premium. However, everything in trading is relative, and IV has its own ebbs and flows within specific ranges. These ranges could vary from 9 to 15 or even 25 to 40. Extreme scenarios, like IV exceeding 40, are often associated with black swan events, unpredictable and rare market occurrences.

Drawing a parallel with the United States, where the VIX (Volatility Index) is actively traded, underscores the potential of a similar instrument in India. WIX, if introduced, could become a lucrative avenue for traders given its liquidity and the inherent volatility in options tied to it.

Expanding the horizon to hedging strategies, options derivatives serve as effective tools for managing risks in a portfolio. Covered calls and protective puts are classic examples. These strategies provide a layer of protection against adverse market movements, ensuring that losses are mitigated, though at the cost of capping potential gains.

Delving deeper into the relationship between implied volatility and FRV, the critical realization is that the difference between them dictates a writer’s profit or loss. The calculations are straightforward – when IV exceeds FRV, sellers profit, and vice versa. However, understanding the dynamics of this difference is crucial for an option seller’s success.

A profound revelation surfaces when analyzing the profit and loss dynamics of option sellers over a more extended period. A plotted chart featuring implied volatility and FRV differences unveils a sea of green and red bars. Greens denote profits, while reds signify losses. The key takeaway is that, over time, the cumulative effect of these bars tends to zero, suggesting that, on average, option sellers neither incur significant profits nor substantial losses.

This equilibrium, however, comes with nuances. It assumes static hedging, a constant range or delta for risk management. Static hedging helps control the intensity of losses, ensuring that catastrophic red bars are avoided. The trade-off is a limitation on potential gains.

At this juncture, the concept of dynamic hedging enters the scene. Dynamic hedging implies adjusting hedges based on forecasts and market conditions, allowing for more flexible risk management. However, this approach introduces subjectivity and requires meticulous tracking of market dynamics.

The essence of option selling lies in forecasting. It’s not just about collecting premiums; it’s about understanding the market’s expectations and positioning accordingly. The difference between IV and FRV is a reflection of the market’s perceived volatility versus actual volatility. Option writers need to anticipate these fluctuations and act accordingly.

In a fascinating revelation, the blog addresses the misconception that option selling is a perpetual profit generator. While it might yield short-term gains, sustaining profitability over the long run requires astute forecasting and adaptability. Merely selling options daily without a clear forecast is akin to relying on luck, a strategy bound to falter.

Exploring the nuances of directional selling in options trading introduces us to a realm where forecasting takes a unique form. Unlike traditional forecasts where traders attempt to predict the market’s upward or downward trajectory, the focus here is on anticipating a predefined range. This entails setting expectations on the upper and lower bounds within which the market is anticipated to fluctuate. The strategy involves a meticulous blend of volatility forecasting, risk assessment, and strategic option writing.

The initial step in this approach is to develop an independent forecast, distinct from the conventional market direction predictions. This forecast revolves around defining the upper and lower limits that one believes the market will not breach. In essence, it introduces the concept of a stop-loss within the forecasted range, offering a defined exit point if the market deviates beyond expectations.

Here, implied volatility (IV) assumes a central role. Implied volatility encapsulates the market’s expectation of future price movements. To forecast IV, traders often delve into statistical techniques, and one such method gaining attention is the General Autoregressive Conditional Heteroscedasticity (GARCH) model. While the name might sound complex, the modified GARCH serves as a robust tool to forecast volatility and subsequently set the stage for directional option selling.

The crux of this methodology lies in converting the forecasted IV into a range. Comparing this range with the market’s current conditions provides a nuanced understanding of whether the market is pricing in more or less volatility than anticipated. Let’s break this down further.

Consider the example of Nifty, with a current value of 21,500. If the market is expecting a range of 320 points, calculated as 1.5% of the current value, the upper forecasted limit would be 21,680, and the lower limit would be 21,350. This becomes the trader’s forecast based on their chosen methodology.

Now, the modified GARCH model comes into play. Utilizing this model, traders can fine-tune their volatility forecast based on historical price movements, adjusting the upper and lower bounds accordingly. It’s essential to note that this is just one approach, and traders might have their unique methods for forecasting.

Once the forecasted range is established, the trader scrutinizes the market’s current pricing. If the market is indicating a broader range than the trader’s forecast, there’s a compelling opportunity to engage in directional selling. For instance, if the expected range is 21,640 to 21,350, and the market is pricing in a broader range of 21,700 to 21,300, the trader recognizes an imbalance in expectations.

At this juncture, the trader can strategically initiate option selling. If the trader foresees a bullish scenario, the focus may shift to selling calls further away from the current market price. Conversely, in a bearish scenario, puts closer to the market price might be sold. The goal is to capitalize on the perceived discrepancy between the forecasted range and the broader range the market is implying.

The element of risk management remains paramount. Even in directional selling, the trader acknowledges the potential for gap ups or gap downs, representing overnight changes in market conditions. These gaps, traditionally perceived as risks, can also be viewed as opportunities if they align with the trader’s directional forecast.

This brings us to the intriguing concept of gap risk and gap reward. The gap risk is the potential for an adverse price gap beyond the trader’s forecasted range, while the gap reward presents an opportunity if the gap aligns with the trader’s directional stance. This reframing of gaps challenges the conventional notion of them being purely risks and introduces the idea that gaps can work in favor of a directional trader.

Navigating the intricacies of options trading requires a multifaceted approach that goes beyond conventional market direction predictions. Delving into the world of directional selling introduces a unique strategy where traders anticipate a predefined range instead of predicting a market’s upward or downward trajectory.

The process involves a meticulous blend of volatility forecasting, risk assessment, and strategic option writing. One key element in this strategy is implied volatility (IV), which encapsulates the market’s expectation of future price movements.

To begin, traders develop an independent forecast, setting upper and lower bounds within which the market is expected to fluctuate. A stop-loss within this forecasted range acts as an exit point in case the market deviates beyond expectations.

Statistical techniques such as the General Autoregressive Conditional Heteroscedasticity (GARCH) model come into play for volatility forecasting. GARCH provides a forward-looking indicator, essential for anticipating future market conditions.

Once the range forecast is established, the trader scrutinizes the market’s current pricing. If the market is indicating a broader range than the trader’s forecast, there’s an opportunity for directional selling. The goal is to capitalize on the perceived discrepancy between the forecasted range and the broader range the market is implying.

Now, let’s delve into a scenario where gap risk becomes a crucial consideration. If there’s a 2% gap risk for one day, it doesn’t equate to a straightforward 14% gap risk for seven days. The occasional nature of gaps introduces nuances. In the example given, a more accurate calculation might yield a 3.7% gap risk for seven days. This insight is essential for traders engaged in positional writing.

The concept of gap risk and reward takes an interesting turn. Instead of viewing gaps solely as risks, there’s an acknowledgment that gaps can also present profitable opportunities. This perspective challenges the conventional notion and encourages traders to explore the potential benefits associated with market gaps.

Moving forward, the GARCH model assumes a prominent role in forecasting implied volatility. GARCH, a modified version, helps in fine-tuning volatility forecasts based on historical price movements. The goal is to improve the strike rate of range forecasting, providing a foundation for profitable trades.

Now, the focus shifts to the selection between two trading strategies: selling a straddle and selling a strangle. A straddle involves selling both the ATM call and put, while a strangle involves selling options out of the money.

The decision between straddle and strangle hinges on the trader’s forecasted range in comparison to the market’s range. If the market’s range is wider than the trader’s forecast, selling a straddle is preferable. However, if the trader’s forecasted range exceeds the market’s range, synthetic selling of a straddle might be the optimal choice.

To determine the optimal strategy, calculations involving synthetic positions are essential. These calculations ensure that the risk-reward ratio remains balanced at 1:1. The intricate dance of probabilities and synthetic positions is best handled by algorithms, providing a nuanced approach to strike selection.

In essence, the trader aims to sell options synthetically at implied volatility levels that align with their forecast. The strategy adjusts dynamically based on the market’s conditions and the trader’s expectations.

As traders navigate the complexities of directional selling, understanding the mechanics of forecasting, implied volatility, and the strategic selection of option positions becomes paramount. While the intricacies may seem daunting, embracing these concepts can empower traders to make informed decisions in the ever-evolving landscape of options trading.

Navigating the intricate world of options trading demands a nuanced approach, particularly for those wielding a substantial capital exceeding 50 lakhs. In this discussion, we unravel a strategy tailored for seasoned traders who seek to optimize their returns through directional selling. Although the theory remains consistent for smaller capital, the potential for significant profits becomes more apparent with larger sums.

Let’s delve into the practicalities using Bank Nifty as an illustrative example. In a one-lot trade, the profit potential per day stands at a robust 2450 rupees. Even if one secures only 70% of this profit due to market fluctuations, it translates to a considerable 1700 rupees. Considering an 80% strike rate, accounting for stop-loss exits, the net strike rate becomes 60%.

Calculating the daily net profit, we find that with a 60% net strike rate, the trader stands to make 1000 rupees per day. With approximately 21 trading days in a month, the potential monthly return amounts to 21,000 rupees. Importantly, this is achievable with a maximum capital deployment of 1.5 lakh rupees.

Analyzing the returns, the raw return stands at an impressive 14%. However, it’s crucial to consider hedging to protect these gains, which effectively halves the return to 7%. It’s worth noting that these calculations do not incorporate brokerage or slippages, which can contribute to an additional 4% reduction. Despite these considerations, the trader is still left with a conservative 3% monthly return.

This strategy assumes that traders possess the discipline to engage in effective range forecasting, a fundamental element for success in option writing. Achieving a strike rate above the standard 65% is pivotal for profitability. To enhance the accuracy of volatility forecasts, traders can leverage statistical models like the General Autoregressive Conditional Heteroscedasticity (GARCH) model.

The decision between selling a straddle or a strangle hinges on the trader’s implied volatility expectations. If expectations are low, a straightforward approach is to sell a straddle. However, when expectations are high, a more intricate process involving machine-driven calculations is employed to pinpoint the optimal straddle for selling, aligning with the trader’s forecast.

Implementing an 80% profit target and a continuous profit trail strategy adds further sophistication. The ability to exit when profits hit 80% and trail continuously based on peak profits ensures that traders maximize gains while mitigating risks associated with sudden market fluctuations.

In the realm of options trading, successful money management is paramount. The blog discusses the importance of trailing profits, setting specific exit points, and utilizing alerts to stay informed. This method proves particularly useful during periods of theta decay when markets close, and sudden fluctuations can significantly impact gains.

The blog emphasizes that these returns are conservative estimates, and individual results may vary. Nonetheless, directional selling offers a disciplined and calculated approach for traders with a sizable capital base.

In conclusion, the directional selling strategy provides a sophisticated yet potentially rewarding avenue for seasoned traders with a capital exceeding 50 lakhs. The core lies in effective range forecasting, bolstered by statistical models like GARCH. By selecting the optimal straddle based on implied volatility expectations, traders can enhance their strike rate and capitalize on profitable opportunities. A continuous profit trail strategy further fortifies the approach, maximizing gains while navigating the intricacies of the options market.

For traders seeking to delve deeper into advanced option trading strategies, the upcoming Option Symposium on January 27-28, 2024, offers a unique opportunity. Hosted within the Bombay Stock Exchange building, the symposium brings together industry experts to share insights into diverse trading strategies, including mean reversal in uptrends and navigating volatility during election years.

In the dynamic landscape of options trading, staying informed and mastering advanced strategies is key to success. The directional selling approach, when executed with precision and prudence, can unlock the potential for consistent and substantial profits. To complement this learning, the Option Symposium provides a platform to glean insights from seasoned experts and further elevate one’s trading game.