Vertical Spreads

As defined by investopedia.com, An options trading strategy with which a trader makes a simultaneous purchase and sale of two options of the same type that have the same expiration dates but different strike prices is called as Vertical spread.

To define in a simpler way, a vertical spread consists of two trades, one buy and one sell of with both either put or call. As both are opposite there is either a net debit or credit. Hence they are also called credit or debit spreads. And depending on whether the option is put or call, the names for the vertical spread are

• Credit put spread - A lower put is purchased and a higher put is sold. Typically has a higher probability of success and higher risk. This position is bullish.
• Credit call spread - A lower call is purchased and a higher call is sold. Typically has a higher probability of success and higher risk. This position is bearish.
• Debit put spread - A higher put is purchased and a lower put is sold. Typically has a lower probability of success and lower risk. This position is bearish.
• Debit call spread - A higher call is purchased and a lower call is sold. Typically has a lower probability of success and lower risk. This position is bullish.

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Kelly Criterion - I

The Kelly criterion is a formula used to derive the optimal size of a bet in a series of bets.In some investing scenarios, with some assumptions the formula will do better than any strategy in the long run.

The Kelly criterion says that amount of bet should be same as the ratio of expectation and gain per unit bet. To illustrate, say there is a 60% chance that an investment goes up by 5% and 40% chance that it goes down by 3%. Then,

f = Expectation per unit bet / Gain per unit bet

f = (0.6 * 0.05 - 0.4 * 0.03) / 0.05

f = 0.36

That is, we must bet thirty six hundredth of our portfolio to maximize our success. Any bet below is too conservative and any bet above is too aggressive.It is a recommended that the bet actually be only half of the Kelly fraction to avoid incorrect probability and give room for higher losses. Kelly criterion works well only for defined risk trades like vertical spreads, and will not work well for undefined risk trades.

Volatilities - II

Implied Volatility is used to determine the expected move of the underlying. IV as a metric represents a 1 standard deviation expected move in the underlying for the next year. We can also estimate expected moves for various time frames using this formula

1SD Move = Price * IV * sqrt(DTE/365)

where DTE is Days to expiration

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Positions as on 7-May-2014

Covered call on TCS:

Long Stock 125 at 2181.25 - 2165
2300 Call written for 30 - 25
Profit = 625

Strangle on NIFTY:

7300 Call written for 104 - 44.05
6500 Put written for 109 - 161.3
Profit = 382.5

Bullish Naked Call:

6800 Call bought for 214 - 182
Profit = -3200

Net profit = -2193

Volatilities

There is historical volatility and implied volatility. One is an input to the option pricing module, the other is an output of the model. Together they create 4 scenarios

Historical Volatility	Implied Volatility	Trend
Low	Low	Sideways
Low	High	Expect a big move
High	Low	Consolidate
High	High	Trend Continues

Naked put

A naked put consists of a single trade, writing a deeply out of the money put with the intention of buying the stock at the strike value of the put. If the stock  stays above the strike, the put expires worthless and the profit is equal to the value of the put. If the stock falls below the strike, then the loss is the difference between the share and the strike price less the the premium collected. But on the other side the stock can now be purchased at the put strike price less the premium.

To take an example, 150 Put for BHEL(179.5) is written at 1.7. At a lot of 2000 the total value is 3400 at a margin of 42000. If the stock remains above 150, the return is roughly 8%. If it falls below, then we can purchase the stock at a 30 Rs discount as against buying it at 179.5. If the stock crashes further, it is better to buy the put back at a loss. Suggest trading to reduce the losses at this point.

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Positions as on 2-May-2014

Covered call on TCS:

Long Stock 125 at 2181.25 - 2209
2300 Call written for 30 - 40
Profit = 2218.75

Strangle on NIFTY:

7300 Call written for 104 - 56.3
6500 Put written for 109 - 154.25
Profit = 122.5

Bullish Naked Call:

6800 Call bought for 214 - 211
Profit = -150

Net profit = 2191.25