Author: shyam

Analysis: Bhavin Desai’s Bull Spread on ITC

Bhavin Desai of Motilal Oswal Securities was on CNBC saying that one may buy ITC 350 Call and advises shorting 360 Call. This is a 350/360 long call spread on ITC. Let’s see how the trade works.

The greeks

ITC Bull Spread Greeks

The 360 call has a θ of -145.36 and it the model premium is 3.04. This means that the time decay will make the option worthless in a couple of days. Not bad since you are an option seller.

The 350 call is already ITM (the stock closed at 352.70) and the last traded price, Rs. 6.3 is less than the model price of Rs. 7.49. Not a bad deal.

Payoff diagram at expiry

ITC Bull Spread P&L

ITC Bull Spread Breakevens

 
 
ITC needs to be above Rs. 354.35 at expiry for this trade to break-even. Max loss is the premium paid upfront (Rs. 4350)

The right trade for the wrong reasons?

The transcript on moneycontrol says:

ITC has had some amount of shorts right from the beginning of this expiry and since then it has not done anything and once again since yesterday’s trade we have been seeing some amount of long additions. So, a call spread or rather a bull call spread is something that can be advised.

We are not really sure what that means. The reason why you would put a bull spread on is if you are moderately bullish about the stock and want to mitigate the cost of buying the lower strike by selling a higher strike.

Reference

Buy ITC 350 Call, short 360 Call: Bhavin Desai

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Options Liquidity

Liquidity (or the lack thereof)

Open interest is a measure of liquidity of a particular market. For each buyer of a contract there must be a seller. From the time the buyer or seller opens the contract until the counter-party closes it, that contract is considered ‘open’. OI refers to the total number of derivative contracts that have not been settled.

Other than a few select indices and stocks, there is absolutely no liquidity in the option market. Here’s a chart of the latest total OI for the nearest (April) expiry:

OI April

And its worse for the next series:

OI May

Bid-offer spread

The problem with trading illiquid options is that the bid-offer spread ends up killing your trade. Compare and contrast the spreads for UNITECH and DABUR:

UNITECH APRIL

UNITECH MAY

DABUR APR

DABUR MAY

Don’t stop at trade setups

When you conceive option trades, make sure you consider liquidity constraints. Otherwise, your trade is likely to remain on paper.

The liquidity footprint is not static. For example, RCOM, which was #8 in Jan is nowhere to be found in the liquid dozen in April:

OI Jan

Monitoring liquidity risk is as important as checking your deltas and P&L and can often make or break a trade.

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Long Call Spread

Introduction

Suppose you are moderately bullish about a stock/index and you feel that it has room to run but its not going to be gangbusters. Then you could buy a call outright but that could be expensive. What you could do is buy the call and then sell a call at a higher strike to mitigate the cost of your (moderately) bullish outlook.

A long call spread (or a bull spread) contains two calls with the same expiration but different strikes. The strike of the short call is higher than the strike of the long call. The short call’s main purpose is to help pay for the long call’s upfront cost.

Example

long call spread

The Max loss is the net premium paid: Rs.1825.00
For the trade to break even, the NIFTY should end above 6786.50 at expiration (April 24).
The Max profit at expiration is Rs.3175.00

The greeks

The long call is more sensitive to changes in the underlying than the short call due to its ATM-ness.
All the greeks, δ, θ, κ, and λ are higher for the long call than for the short call.
The long-call will lose money faster to time decay than the short call.

By freezing all other inputs, you can observe θs across different strikes of the bull spread at different values of the NIFTY as expiry approaches:

Bull Spread Theta

Time decay is helpful to this position when it is profitable and harmful when it is loss-making.

Similarly, observe how δs of the bull spread at different values of the NIFTY as expiry approaches:

Bull Spread Delta

Exiting the trade

If the trade is profitable, allow time-decay to work for you. You could even hold this to expiration. If the position is moving against you, it is best to cut your losses.

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Introducing The Facebook National Bank

We had pointed out back in February as to how startups are disintermediating banking and that given the amount of data that both banks and Facebook have on us, it is only a matter of time that we saw a “Facebook National Bank.” Turns out that it is now a reality:

Facebook is readying itself to provide financial services in the form of remittances and electronic money. The social network is only weeks away from obtaining regulatory approval in Ireland for a service that would allow its users to store money on Facebook and use it to pay and exchange money with others. “Facebook wants to become a utility in the developing world, and remittances are a gateway drug to financial inclusion.”

Source: Facebook targets financial services

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Trading Options, Know your Greeks

The first rule of trading options is that options are not stocks. Just because the underlying stock moves doesn’t mean that the option moves in the same direction. You need to think of options as a separate asset class.

For example, if you are in a ship at sea, you know that the tides are linked to the phases of the moon. But the tides are only a small part of what is involved in sailing, isn’t it? You should also know about ocean currents, developing weather patterns, presence of icebergs, reefs, etc… Similarly, the option premium is only lightly tethered to the value of the underlying.

The key thing to remember is that the option premium is a function of intrinsic value, time value and volatility.

Lets say you buy a April NIFTY 6750 Call @ Rs. 59.70 when the NIFTY was trading at 6733.10. Say, the NIFTY rallies by 1% to 6800.431 the next minute. Would your call option also increase by 1%? Nope. It will probably tick up by 0.5% Why? because the delta(δ) of that option is 0.49

Read: Forensics: NIFTY Options – Delta(δ)

But what if the NIFTY rallies tomorrow by 2%. Will your call option premium now increase by 1%? Nope. There are two opposing forces that are now acting on the option.

The first, and the strongest force, is time decay. It is known to crush the best laid plans of both men and mice.

Read: Forensics: NIFTY Options – Theta(θ) Decay

The second, is volatility. As a buyer of an option, you want volatility to go up, and NIFTY rallying by 2% in a day is just that.

Read: Forensics: NIFTY Options – Vega(κ)

It is not only important to mind your greeks at the time of putting on the trade, but you need to monitor it constantly. Greeks change not only as the underlying moves, but also as expiration approaches.

Read: Forensics: NIFTY Options – Gamma(γ)

Remember your Greeks:

Vega(κ) Theta(θ) Delta(δ) Gamma(γ)
Measures the impact of change in volatility (σ) Measures the impact of change in time remaining Measures the impact of change in underlying price Measures the rate of change of delta(δ)
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