The art of setting up a position

We have so far discussed how to choose an option strike using the implied volatility rule and the liquidity rule. Choosing the right strike is only one part of the trading plan. You have to then decide whether it will be meaningful to set up a position to bet on your view on the underlying. This week, we discuss the process that will help you decide whether a position will be economically meaningful to set up or not.

Determining profitability

Suppose in expectation of an underlying moving to 14,000, you choose to buy the 13,500 strike call option on the underlying based on the implied volatility rule and the liquidity rule. What is the maximum profit you can expect if your view turns right?

You should determine the expected profit at option expiry. And that means you should first determine the price of the option if the underlying trades at 14,000 at option expiry. At expiry, in-the-money (ITM) options have only intrinsic value, and both at-the-money and out-of-the-money options have zero value. This is because time value of all options declines to zero at expiry. So, the 13,500 strike call, being ITM, will be worth 500 points at expiry if the underlying trades at 14,000. Suppose you buy the option today for 150 points, you have an upside potential of 350 points (500 minus 150), translating to more than two-to-one reward-to-risk ratio (350 divided by 150).

If a long position you want to set up today will be profitable at expiry, it would be even more profitable if the underlying reaches your price target of 14,000 well before expiry. This is because you will get some time value as well when you sell the option. So, the option price will be worth 500 points (intrinsic value) plus time value. You can, therefore, conclude that it is meaningful to set up the long position based on your view on the underlying.

We have to look at the profitably of the position at expiry because you cannot determine the time value of an option at any time during the life of the option. This is because time value of an option is the residual factor and is arrived at by deducting the intrinsic value from the actual traded price of the option.

Optional Reading

You can determine option value (not the price) at any time during the life of the option using the Black-Scholes-Merton (BSM) model. The issue, however, is that the assumptions of the BSM model do not hold in the actual markets because of which the model will undervalue or overvalue options depending on the market condition. Therefore, you cannot assume that option value is the same as option price except at expiry. This is because, at expiry, the option will only have intrinsic value.

There is another reason for determining profit at expiry. Remember, you view on the underlying is based on chart analysis. With notable exceptions such as Gann trading, technical analysis will not help place a time-frame on your view. That is, using the charts, you may be able to state with some confidence that the underlying will reach 14,000. But you may be unable to state a time within which it can happen. Hence, the assumption that the underlying will reach your price target at expiry.

Of course, most option traders do not keep their positions open till expiry. Often, they close their positions for small profits when the liquidity is good. Alternatively, their position could be stopped out before expiry. Or the traders could apply time stops-- close their position after a pre-determined time period if the position does not hit their price target or stop loss.

One last point. Your price-based stop-loss should be based on the underlying if you are trading equity options and on index futures (because spot index is not tradable) if you are trading index options.

(The author offers training programmes for individuals to manage their personal investments. Send your queries to derivatives@thehindu.co.in )

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