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Chapter 5 Averaging while Trading in Options

Averaging Options

Averaging while trading in the options segment is slightly more complex compared to cash positions due to the concept of time value. Time value is basically the portion of an option’s premium that is attributable to the amount of time remaining until the expiration of the option contract. As the days pass, the component of time value in the option premium tends to reduce and does so at a rapid pace towards the end of the expiry. A trader trading in the options segment has only a limited timeframe to get his view correct. Time value goes against the buyer of the option while it tends to be in favor of option seller.

Another major point of difference between averaging in cash market and options is the breakeven point. The breakeven point for options is strike price + premium paid while for cash positions the breakeven point is the price paid to acquire the shares.

Consider a situation where markets are trading at 10500. Two traders A & B have a bullish view on the market and both of them purchase 10500 CE option expecting the markets to trend higher in the following days by paying a premium amount of Rs120. The option premium paid by both the traders is entirely the time value component. The market after consolidating for a few days witnesses a steep correction all the way till 10100 levels. The traders based on their respective analysis still maintain a bullish view on the market and expect a reversal. Both the traders consider averaging their existing position.

Trader A Trader B
Option Purchased 10500CE 10500CE
Averaged with 10500CE 10100CE
Buying Price of Averaged position Rs37 Rs110
Total Premium Paid Rs157
i.e 120+37
i.e 120+110

Trader A considers averaging his existing position by purchasing a call option of the same strike price as earlier i.e. 10500 strike call option by paying a comparatively smaller premium amount of Rs37. While trader B goes ahead and averages his position with an at the money call option i.e. he pays a higher premium amount of Rs115 and purchases a 10100CE.

In such a scenario, it is better to pay a high premium and purchase ATM call options which have a high delta indicating a high probability of the option expiring in the money. The 10500CE option purchased by trader A has a delta of only 0.19 while the 10100CE option purchased by trader B has a delta of 0.58.

Net Delta Position for Trader A = 0.19+ 0.19= 0.38/2 =0.19

Net Delta Position for Trader B = 0.19+ 0.58 = 0.73/2= 0.38

Higher the net delta higher the probability of the averaged option position ending in the money. Basically, by paying 46% of an extra premium (230/157), B has doubled his probability of making money with his net delta position at 0.38 vs. 0.19 of A.

Trader B would end up in a profitable position by averaging with 10100CE if markets manage to close above 10330 by expiry (Rs230 is the total premium he has paid - Rs120 for the 10500CE and Rs110 to purchase the 10100CE).

Break even for trader B = 10100CE + Total premium paid = 10100 +230 =10330

For trader A, who has averaged his original position with another 10500CE, markets would have to close above 10657 just for the trade to break even (Rs157 is the total premium he has paid to purchase two 10500CE options). Even though the premium paid by trader A is less compared to trader B, the probability of markets closing above 10657 within the current series is very low.

Break even for trader A = 10500CE + Total premium paid = 10500 +157 =10657

Breakeven point for averaged losing Long positions while trading in options is:
CE Options = Lowest strike price purchased + Total premium paid
PE Options = Highest strike price purchased + Total premium paid.

If the market manages to close at 10500, a bounce of 400 points from the current market price:

Trader A at a loss of
Rs23550 (Nifty Contracts* Loss= 2*75*157)
Trader B . Makes profit of
Rs 25500 (Nifty Contracts* Profit= 2*75*170)

Following is the payoff structure:

Closing Nifty Futures Price at ExpiryTrader A Profit/LossTrader B Profit/Loss
1 2 3 4 5 6 7