OTM spread option strategy for long weekends: Shubham Agarwal
Spread is a strategy that involves Buying and Selling of Options of the same stock. The Strike prices are usually different with the same Option type (Call or Put).
Often, we are presented with a week that has a trading holiday on Friday or Monday. This creates long weekends. Long weekends pose problems for Option traders on two fronts.
1. Time Value Drop in Premiums
Option premium has a crucial element in its premiums that is directly related to time. This means that if the price of the underlying stock or index were not to move a single paisa for the entire expiry, the premium would go down bit by bit every day. This phenomenon is called Theta Decay. Problem of drop in premiums due to Theta Decay becomes bigger when the price cannot move for 3 straight days. In any case the premium is going to fall due to time. This becomes a bigger problem if you are close to expiry.
2. Opening Gaps post weekend
Our markets are dependent on many national as well as international developments. Market keeps the prices in sync with the developments. However, a trading holiday especially before or after the weekend may not be able to do so. As a result, what happens is that the lack of sync gets a bigger impact when we open after the long weekend. Negative impact will get a bigger price cut in the opening hour. Similarly, a big gap up in case of positive development when we were in our day-off.
Solution: OTM Spread Strategy.
What is this strategy?
OTM: Higher Strike Calls and Lower Strike Puts compared to the current market Price are called OTM Strikes.
Spread: Spread is a strategy that involves Buying and Selling of Options of the same stock. The Strike prices are usually different with the same Option type (Call or Put).
In OTM Spread strategy that we are referring to, one Buys an OTM Option and Sells a Further OTM Option.
So, for a Call OTM Spread, one would Buy a higher strike Call and Sell even further higher strike Call. For Put one would Buy a lowers strike Put and sell even lower strike Put. Both the options are expected to be of the same expiry.
Why Do This?
While trading an expected move after the long weekend, we are expecting a big move. So, for a bullish move, a favourable development is expected to push much higher. At the same time an unfavourable development can have equally punishing impact. So, while preparing for Gap Up we should prepare for the Gap Down as well. Secondly, the problem of time value drop has to be solved.
Firstly, OTM Spread is more sensitive to the favourable move but less sensitive to unfavourable move (See in the example).
As far as time value is concerned, the Buy will lose on Time value, but the Sell Option will gain. This will offset.
Example: RELIANCE @ 2687 (on 23rd Oct). Assuming 3 days off, we check Bullish OTM Spread’s expected performance after 3 days both 3% up and 3% down (with the grey line on the chart).
The chart shows that if ~3% up one would be making 4400 while similar or even bigger fall would cost just 2000.
The best way to trade long weekends is with OTM Spreads both bullish and bearish.
Bymoneycontrol
