Have you noticed fast moves during expiry week in your options prices & suddenly on Friday with start of the new expiry, options move slower? If you recall the state of mind while trading the expiry week, it comes with a lot of anxiety & restlessness while other periods are different. If we know the root cause of why this happens it can help us make our trading decisions better.
Consider a scenario that you are driving on a highway, the speed limit is 100 km/hr you drive on that for a while and then take an exit towards an internal road where the limit is 40 km/hr, generally people tend to overshoot the speed limit several times as you are habituated to drive at a high speed and it takes a sometime to adapt to the change.
Similarly, if you are driving in an internal road and suddenly hit the highway and vehicles around you are too fast, it requires more attention for some time till you adapt to it.
Option trading also has their drastic change in movements as it migrates from one expiry to the other. When expiry is nearby, even small moves in the underlying cause wild swings in option prices and in a new expiry even a decent move in the underlying barely moves the option price. If we learn this behaviour, we should be able to adapt to these changes for good in our trading book. Let’s see this with an example:
In the above table, first scenario is when it is 2 days to expiry and second scenario states 30 days to expiry. In the first scenario we see that with a 1% move in the underlying the option price more than doubles with a whopping 108% gain whereas the same movement in the underlying in a new expiry gives only a 24% movement in price that’s 1/4th of the movement compared to expiry week.
This is exactly what happens when you are trading through the expiry and as suddenly a new expiry comes in, you take time to adapt this change and still expect movements which aren’t practical.
In terms of option greeks, this is Gamma effect and to handle this behaviour to our favour we can neutralize it with simple fixing in trade size.
Mid Expiry
Let’s take mid expiry as our base trading period. In terms of days that would be 15 days to expiry for a monthly expiry. This is the base period let’s says generally you trade 10 lots of such an option then in this period you should trade only 10 lots.
Expiry Week
Since this is the period with wild swings in option prices, to avoid anxiety or being whipsawed by volatility the best decision should be to reduce your bet size to half. So normally if you trade 10 lots as base, you can bring down your positions all the way to 5 lot’s as you approach expiry. This will neutralize the daily Profit & Loss and will help with consistency in your trades.
New Expiry
This is when suddenly from a high momentum in option price you enter a zone of low movement. Even if you underlying forecasting is right your options trades will not yield you similar profits. In this zone, you can ideally increase your bet size to say double i.e. if you normally trade 10 lots you may consider 20 lots as the option prices will move slower and to generate a normalized Profit & Loss this will help.
Summary
Smoothening your trades with time and movement is an important fix for an intraday trader. Trades need to adapt to changing gamma which can be achieved by simply increasing and decreasing your bet size in different expiry times.
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