Choose a higher strike Call in a rising stock / Lower strike Put in falling stock that you expect to ATM. You have a potential Zero to Hero on your hand.
We all hear stories at every expiration about the one option that went from Re 1 to Re 250. The logic is not very complicated. Let’s understand the secret behind these zero-to-hero opportunities that lie in the systemic drivers that push premiums up.
For any combination of expiration symbols, there are multiple call and put options with different strike prices. These strike prices can be divided into 3 main categories.
ATM (At the Money): Strike close to the current market price.
OTM (out of the money): Call Strikes higher than the current market price and Put Strikes lower than the current market price.
ITM (In-the-Money): Call Strikes lower than the current market price and Put Strikes higher than the current price.
We will concentrate on 2 drivers moving premium option.
1. Share price / index
2. Time left to expire
On the expiration day, the second element will affect the most, as the already limited time now quickly goes to zero. This results in a rapid decline in premiums caused by the passage of time. Most of the expiration day traders take advantage of this fall by selling OTM call and put options.
Pricing is pretty straight forward, rising prices will help the Call premium to rise and falling prices will help set premiums to rise.
It’s all very simple, but when the very limited time left to expire and the price action combine, magic happens and Heros are born. To understand this we need to understand the following line.
Option premium increases with probability that option expires ITM.
This may not make much of a difference during expiration, but on the last day of expiration, when the time-related decline in premium is in full swing, and making even a small move of 3-5 percent becomes a limited probability because the stock /index only has a few hours to do so.
In such a situation, despite every small increase, the Call premiums may not increase in the race with time.
Unless the stock/index is approaching the strike and the OTM option now becomes ATM.
(the stock rises to the Call option strike or falls to the Put Option Strike).
Now the probability increases from almost 0 percent to 50 percent, as does Option Premium.
This systemic change changes everything. The option, which could not have had a chance to expire with any value, may now end the expiration with a value of some money. The systemic factor that causes this to happen is known as Gamma, which is the rate at which the probability of expiring the ITM moves. The phenomenon is also known as the Gamm Explosion.
Auxiliary function: Select a higher strike Call in a rising stock / Lower strike Put in falling stock that you predict will become an ATM. You have a potential Zero to Hero on your hand.
Remember, it is the law of nature that these opportunities will have dramatically lower success rates, but then if there is a Rs 1 to 10 opportunity, you just need a 20 percent success rate to double your money.
Disclaimer: The views and investment tips expressed by investment experts on Moneycontrol.com are their own and not those of the site or its management. Moneycontrol.com advises users to check with certified experts before making investment decisions.
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