Impact of implied volatility on selected stocks on NSE for … · 2020. 9. 23. · Impact of implied volatility on selected stocks on NSE for designing Option trading strategy . Author

Impact of implied volatility on selected stocks on NSE for designing Option

trading strategy

Author

Prasad Sharma

Student MBA-Finance

MIT-WPU School of Management (PG), Pune, India

[email protected]

Co-Author

Dr Ujwala Bairagi

Assistant Professor, MIT-WPU School of Management (PG), Pune, India

[email protected]

Abstract: In this paper we have tried to understand the implication of volatilities especially

Implied volatility on the option pricing and based on that have created an option trading strategies

for the stock option of three companies which were selected randomly. In this research we have

calculated Implied volatility of last 8-9 years of historical option data and have created a profit

making option trading strategy which was back tested on the last 8-9 year’s historical data. In back

testing we found that the strategies created for the option trading have generated good profit making

results and there were no overall losses in any of the strategy.

Keywords – Volatility Studies, Option trading strategies, Derivative Research

Introduction

The Research Paper is an effort to study volatilities in the option pricing using Black and Scholes

Model with respect to the price of India stocks and to make Derivative Option trading strategies based

on the same study.

Options prices content three components first Intrinsic Value, second is Time Value and the third

component is Volatility value the more volatile the stock is there is higher the volatility value

attached to it. In this research we have studied about historical volatility and Implied volatility.

If historical volatility is more than the Implied volatility, then the option is cheaply priced and if

Implied volatility is more than the historical volatility then options are expensive. The at the money

options and just out of the money options don‟t have intrinsic value therefore it has only Time value

and Volatility value which makes them our best options to trade using this trading strategy as our

strategy is based on volatilities.

Journal of Seybold Report ISSN NO: 1533-9211

VOLUME 15 ISSUE 9 2020 41

mailto:[email protected]

In this strategy we are sold Straddle when the Implied Volatility has crossed the upper extreme and

have started to shrink with a risk reward ratio of 1:3. And bought the straddle when Implied volatility

crossed the lower extreme the lower extreme and started to rise.

The research paper has one more strategy of selling the straddle just after the results are announced

and on that day Implied volatility is more than the historical volatility. All the Strategy where back

tested over a period of 8 years and have generated good amount of profit. And at less risk compared to

blindly trading over the instinct

Objectives

1. To study the role of volatilities in the option pricing using black and Scholes Model.

2. To formulate a profit making Derivative Trading Strategy using the Study of Volatilities for

the Derivative Options of the following three Companies.

i. Power Finance Corporation LTD. (PFC)

ii. GRASIM Industries LTD

iii. Hindustan Unilever.

3. To formulate a Derivative Trading Strategy on Result Day with the help of volatilities.

Significances of study

To the Organisation: This Study Will Provide the organisation with a well Statistically Proven

Strategy for Derivative Trading on Following Companies

i. Power Finance Corporation LTD. (PFC)

ii. GRASIM Industries LTD

iii. Hindustan Unilever.

The Organisation can sell or suggest the same strategies to its Clients and earn money from it

To the Client: A Statistically Backed Strategies will help clients to earn money at lower risk

compared to Opinion Based Trading.

To the Author: This Research Work Provides a good chance to learn how to make Derivative

Trading Strategies Which Can be used for Trading and Also provide a practical learning Experience

in the Derivative market

Literature Review

To formulate any strategy, we should first learn about the factors affecting the derivative option

pricing along with the volatility. And to learn about them I have read several web pages and some

related research papers on it and below I would be mentioning all the important information I have

gathered on the topic.

Below Image Shows one of the most followed Option Pricing Model



Source: - https://i.pinimg.com/originals/14/c0/19/14c0190d2d6a4e6d45990dc8b7099215.gif

According to this formula Price of an option depends on following factor:

1. Stock Price (S)

2. Strike Price (X)

3. Risk free Interest rate (r)

4. Time for expiry (T)

5. Volatility (σ)

These Factors contribute to the two Parts of the Option Price which are

1. Intrinsic Value

2. Time Value

(Education: Options Education, n.d) says Intrinsic Value for the option can be calculated as

For Call Intrinsic value = Underlying Stock's Current Price(S) - Call Strike Price(X).

For Put Intrinsic value = Put Strike Price(X) - Underlying Stock's Current Price(S).

and Time Value is calculated as

Time Value = Premium - Intrinsic Value for both Call and Put Options

Time Value is basically a function of Risk Free Interest rate (r), Time for expiry (T), Volatility (σ).



ELVIS PICARDO (2019, OCTOBER 14) Strategies for Trading Volatility with Options

https://www.investopedia.com/articles/investing/021716/strategies-trading-volatility-options-

nflx.asp says that there are two kinds of volatility which are historical or implied and they both are

Calculated in annualised terms and are in percentages. Historical volatility is to show volatility of the

past and Implied volatility (IV), is volatility which is implied by the current stock price.

This Article also says Implied volatility is way more relevant than historical volatility for options‟

pricing because it's forward. Implied volatility is like predicting future and Historical Volatility is like

remembering the past, it makes intuitive sense that historical volatility can be an important

determinant of implied volatility, just as the History of a person plays important role in making the

future.

All else being equal, an elevated level of implied volatility will result in a higher option price,

while a depressed level of implied volatility will result in a lower option price. For example, volatility

typically spikes round the time a corporation reports earnings. Thus, the implied volatility priced in by

traders for this company‟s options around “earnings season” will generally be significantly above

volatility estimates during calmer times.

Narasinganallur, Nilakantan & Sethi, with. (2012). Applicability of Black Scholes Model in

Indian Capital Markets. Sates that there is a significant difference between the two BSOPM call price

and the market call price. There were few other observations as below:

i. Most of the time mean prices which were calculated by the BSOPM was greater than

the actual market price.

ii. ii. Generally, the difference of the BSOPM price from the actual market price is

more for the Out-of-Money options as compared to At-the-money and In-the-money options.

iii. iii. As more number of observations carried out, the difference of BSOPM price from

the actual market price increased.

(Dr. M. Tulasinadh, 2017) states that “Black and Scholes model makes the investor to understand

how to price an option strategically and make in-the-money in the option market. The Greek letters

are used to understand to identify the market price fluctuation or simply it is used to calculate the risk

sensitivities in option pricing.”

Research Methodology

Research Problem: To develop a profit making Derivative Trading Strategy with the help of study

of Volatilities for the following three companies Derivative Options.

1. Power Finance Corporation Ltd. (PFC)

2. GRASIM Industries

3. Hindustan Unilever. (HUL)

Pre – Work before Hypothesis Formation

1 Calculation of Implied Volatility (IV) for all Three Companies:

The IV was Calculated using the excel sheet using historical data of last 7-8 years the in-built IV

formula in excel was used to calculate the same.



While calculating the IV only “At The Money” (ATM) and Just Out of the Money(JOTM) Options

are considered.

Extremes: They are those values of IV where it has touched the Upper or lower IV limit and has

bounced back most number of time interpretation of extreme purely depends upon the observer but

the observer should keep in mind that the extreme should be such that on an average you should get at

least two trades in a year. (For both lower and Upper extreme)

Figure 1. PFC IV Graph

Interpretation of Extremes:

Upper Extreme – 60 – Will be used for Selling the Options.

Lower Extreme – 33 – Will be used for Buying the Options.

0.00%

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80.00%

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Final IV



Figure 2. GRASIM Industries IV Graph


Upper Extreme – 48% - Will be used for Selling the Options.

Lower Extreme – 25% – Will be used for Buying the Options.

Figure 3. Hindustan Unilever IV Graph

0

0.2

0.4

0.6

0.8

1

1.2

1.4

06

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Final IV

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FINAL IV




Upper Extreme – 39 – Will be used for Selling the Options.

Lower Extreme – 18 – Will be used for Buying the Options.

Excel sheet 1. Price Reduction Sheet for PFC Option Selling

Date Strike

Call

price Ex price P&L

Put

Price Ex price Loss

Total

Profit/loss

22-Aug-11 150 2.85 0.05 2.8 4 13 -9 -6.2

27-Sep-11 150 5.1 0.65 4.45 1 0.2 0.8 5.25

04-Oct-11 140 5.25 1.5 3.75 9 0.2 8.8 12.55

12-Dec-11 150 7.1 0.05 7.05 7.55 18 -10.45 -3.4

23-Jan-12 160 6.5 38.5 -32 10 0.05 9.95 -22.05

25-Apr-12 180 8.25 0.05 8.2 9.3 31 -21.7 -13.5

20-Sep-12 200 5.4 0.05 5.35 10.25 10 0.25 5.6

24-Jan-13 200 2.85 10.85 -8 6.5 0.05 6.45 -1.55

29-Jan-14 140 3.45 14.3 -10.85 12.05 0.05 12 1.15

15-May-14 240 12.5 86 -73.5 18 0.05 17.95 -55.55

26-Sep-14 250 10.15 27.55 -17.4 16.85 0.05 16.8 -0.6

24-Aug-15 200 20.4 35.2 -14.8 3 0.05 2.95 -11.85

06-Oct-15 250 7.75 0.05 7.7 11.15 14.4 -3.25 4.45

10-Feb-16 160 4.55 0.05 4.5 10.25 5 5.25 9.75

25-Oct-17 145 5.6 0.05 5.55 11 21.25 -10.25 -4.7

25-Jul-18 80 3.5 5.05 -1.55 5.05 0.05 5 3.45

29-Aug-18 85 4.55 0.05 4.5 4.1 5.85 -1.75 2.75

11-Sep-18 82.5 3.25 0.05 3.2 4.3 3.5 0.8 4

25-Sep-18 82.5 3.7 1.35 2.35 6.05 0.05 6 8.35

24-Oct-18 85 4.3 6.85 -2.55 5.2 0.05 5.15 2.6

28-Nov-18 92.5 5.5 8 -2.5 5.05 0.05 5 2.5

26-Dec-18 100 4.85 3.5 1.35 4.55 0.05 4.5 5.85

12-Mar-20 92.5 3.7 1.5 2.2 6.3 3.7 2.6 4.8

profit/loss -100.2

profit/loss 53.85 -46.35

profit 14

profit 17 31

loss 10

loss 7 17

Accuracy 0.608696

Accuracy 0.73913 0.673913

Reduction Sheet Findings for PFC Option Selling: The Accuracy for this Trading Strategy while

selling Straddle is 67.39%

Excel sheet 2. Price Reduction Sheet for GRASIM Option Selling



Date

Strike

Price

Call

Price Ex. Price Loss

Put

Price Ex. Price Loss Profit/loss

16-11-2016 820 19.05 0.05 19 20.3 9.5 10.8 29.8

29-11-2018 860 25.2 0.05 25.15 30.8 45 -14.2 10.95

23-05-2019 860 18 18.4 -0.4 19.8 0.05 19.75 19.35

14-08-2019 740 20.8 0.05 20.75 24.85 30 -5.15 15.6

29-08-2019 720 22.6 25 -2.4 31.36 2 29.36 26.96

26-09-2019 760 24.4 11.3 13.1 34.4 1.7 32.7 45.8

09-10-2019 680 24.15 91 -66.85 29.15 0.05 29.1 -37.75

25-10-2019 720 29.2 71 -41.8 47.1 0.05 47.05 5.25

29-10-2019 720 38.7 71 -32.3 33.4 0.05 33.35 1.05

26-03-2020 480 62.35 31.6 30.75 59.2 0.05 59.15 89.9

profit/loss -35

profit/loss 241.91 206.91

profit 5

profit 8 13

loss 5

loss 2 7

Accuracy 50%

Accuracy 80% 65

Reduction Sheet Findings for GRASIM Option Selling: The Accuracy for this Trading Strategy

while selling Straddle is 65%

Excel sheet 3. Price Reduction Sheet for Hindustan Unilever Option Selling

Date Strike

Call

price Ex price P&L

Put

Price Ex price P&L

Total

P&L

30-Jun-11 340 8.65 0.05 8.6 9.9 17 -7.1 1.5

24-11-2011 400 6.1 13.05 -6.95 20.3 0.05 20.25 13.3

2-05-2013 580 7.05 14.8 -7.75 11.75 0.05 11.7 3.95

13-05-2013 600 1.15 0.05 1.1 15.35 0.05 15.3 16.4

17-05-2013 600 1 0.05 0.95 32.35 4.35 28 28.95

18-07-2013 700 32.75 0.05 32.7 36 106 -70 -37.3

25-07-2013 700 26.15 0.05 26.1 36.15 106 -69.85 -43.75

29-08-2013 620 12 6.95 5.05 28.05 0.05 28 33.05

13-09-2013 640 11.7 0.05 11.65 24.8 11.7 13.1 24.75

4-10-2013 620 17.9 0.05 17.85 26.6 7.5 19.1 36.95

3-06-2014 600 14.8 15.35 -0.55 27.65 0.05 27.6 27.05

15-01-2015 940 20.45 2.5 17.95 32.75 0.45 32.3 50.25

20-01-2015 900 17 41 -24 17.25 0.1 17.15 -6.85

23-01-2015 980 30 0.05 29.95 61 72.55 -11.55 18.4

29-01-2015 960 24.9 0.05 24.85 40 59 -19 5.85

4-02-2015 900 36 0.2 35.8 22.6 12.85 9.75 45.55

29-04-2015 860 33.65 0.05 33.6 29.5 13 16.5 50.1

24-09-2019 2060 63.6 122 -58.4 67.6 0.05 67.55 9.15

25-03-2020 2100 194 102.25 91.75 180 0.05 179.95 271.7

8-04-2020 2480 113.55 0.3 113.25 137 255.05 -118.1 -4.8



profit/loss 353.5


profit 15

profit 15 30

loss 5

loss 5 10

Accuracy 75%

Accuracy 75% 75%

Reduction Sheet Findings for Hindustan Unilever Option Selling: The Accuracy for this

Trading Strategy while selling Straddle is 75%

After Observing the Reduction Sheet Certain Rules are made for Optimizing Risk and Profits.

Rules to be Followed in Back testing while selling for PFC:

1. Always Trade in Shrinking IV.

2. Sell the Options at one day Shrink.(sell it only in one day shrink)

3. If Reduction Range Reduces move out of trade (only for 75% to 50%)

4. Risk Reward 1:3

5. If IV shrinks and jumps to above the previous level and again shrinks then sell the option.

Note: The first Back Testing Rule is already followed in all Reduction Sheet Except PFC Option

selling Sheet

Note: There was Stock split in GRASIM in 2016 therefore data after stock split is only considered

Excel sheet 4. Price Increase Sheet for PFC Option Buying

Date Strike

Call

price Ex price P&L

Put

Price Ex price P&L

Total

Profit\loss

27-12-2012 200 6.7 10.85 4.15 6.9 0.05 -6.85 -2.7

26-06-2015 270 9.35 0.05 -9.3 10.4 26.8 16.4 7.1

16-07-2015 270 6.2 0.05 -6.15 6.25 26.8 20.55 14.4

11-08-2015 250 5.85 0.05 -5.8 7.6 31 23.4 17.6

1-01-2016 205 7 0.05 -6.95 8.4 35.8 27.4 20.45

20-01-2016 150 4.3 19.4 15.1 4.8 0.05 -4.75 10.35

1-07-2016 170 7.5 40 32.5 9 0.05 -8.95 23.55

1-11-2016 122.5 4.4 4.35 -0.05 3.95 0.05 -3.9 -3.95

15-03-2017 140 1.45 2.5 1.05 6.4 0.05 -6.35 -5.3

29-12-2017 122.5 4.2 0.05 -4.15 3.75 3.9 0.15 -4

23-02-2018 110 2.1 0.05 -2.05 6.9 24.3 17.4 15.35

27-04-2018 87.5 3 0.05 -2.95 3.7 7.15 3.45 0.5

26-12-2019 112.5 3.4 7.2 3.8 4.1 0.05 -4.05 -0.25

profit/loss 19.2


profit 5

profit 8 13

Loss 8

loss 5 13

Accuracy 38.46

Accuracy 61.54 50



Reduction Sheet Findings for PFC Option Buying: The Accuracy for this Trading Strategy

while Buying Straddle is 50%

Excel sheet 5. Price Increase Sheet for GRASIM Option Buying

Date

Strike

Price

Call

Price

Exercise

Price P&L

Put

Price

Exercise

Price P&L

Total

P&L

02-11-2016 940 23 0.05

-

22.95 23.95 125 101.05 78.1

19-10-2017 1140 12 53 41 19.5 0.05 -19.45 21.55

29-12-2017 1180 25.8 19.1 -6.7 39 1.25 -37.75 -44.45

18-05-2018 1080 16.75 0.05 -16.7 33.45 17.55 -15.9 -32.6

25-Jun-18 1020 5.4 0.1 -5.3 14.65 17.6 2.95 -2.35

profit/loss

-

10.65


profit 1

profit 2 3

Loss 4

loss 3 7

Accuracy 20

Accuracy 40 30

Reduction Sheet Findings for GRASIM Option Buying: The Accuracy for this Trading Strategy

while Buying Straddle is 30%

Excel sheet 6. Price Increase Sheet for Hindustan Unilever Option Buying

Date Strike

Call

price Ex price P&L

Put

Price Ex price P&L

Total

Profit/loss

06-02-2014 570 22.75 0.05 -22.7 5.1 15.15 10.05 -12.65

25-04-2014 590 16.5 0.05 -16.45 21.75 26.8 5.05 -11.4

17-02-2017 850 4.4 6.5 2.1 10.35 0.05 -10.3 -8.2

14-03-2017 920 13.9 0.05 -13.85 16.15 1.1 -15.05 -28.9

21-04-2017 910 7.9 37.85 29.95 11.7 0.05 -11.65 18.3

29-01-2018 1400 33.35 0.05 -33.3 33.4 79 45.6 12.3

26-02-2018 1340 24.8 0.05 -24.75 23.45 6.5 -16.95 -41.7

23-03-2018 1320 24.1 150 125.9 31 0.05 -30.95 94.95

18-04-2018 1460 10.2 26.65 16.45 17.7 0.05 -17.65 -1.2

18-04-2019 1740 55.7 42 -13.7 42.5 0.05 -42.45 -56.15

30-04-2019 1760 43.25 22.5 -20.75 44.55 0.05 -44.5 -65.25

24-01-2020 2080 56.75 178 121.25 37.35 0.05 -37.3 83.95

profit/loss 150.15

profit/loss -166.1 -15.95

profit 5

profit 3 8

loss 7

loss 12 19

Accuracy 0.4167

Accuracy 0.25 29.63



Reduction Sheet Findings for Hindustan Unilever Option Buying: The Accuracy for this

Trading Strategy while Buying Straddle is 29.62%

After Observing the Reduction Sheet Certain Rules are made for Optimizing Risk and Profits.

Rules to be Followed in Back testing:

1 Always Buy in increasing IV

2. Book Profit if the price increases and falls to the given levels in the table.

From to

75% 50%

100% 75%

200% 100%

300% 200%

Etc. Etc.

3. Risk Reward 1:3

Hypothesis

H0 = The Derivative Trading Strategy will have good returns at a lower risk if all the rules created

for Trading Are Followed.

H1 = The Derivative Trading Strategy will not have good Returns even if all the rules created are

followed.

Steps followed in Back Testing

Step1 – Note down date according to the rule 1 of every strategy

Step2 – Visit NSE website for historical option Data of that and select strike price which is just out

of the money on that day and enter settle price of that day of the same month expiry as entry price. (If

expiry is in less than 5 days then select next month expiry)

Step3 – Identify the lot size from the same historical data from the OI coulomb and enter in the Qty

Coulomb.

Step4 – Calculate the stop loss according to the rule and see whether the option price has hit the

stop loss before expiry at any given point if yes then enter it as the exit price and directly go to step 6

or else go to step 5.

Step5 – Go to expiry date data and enter the closing price of the option of same strike price as exit

price.

Step6 – If you are doing it for selling Strategy Then Put „B‟ in first „B/S‟ coulomb and „S‟ in

second „B/S‟ coulomb and vice a versa for Buying

Formulas in the excel sheet will take care of the calculation of the following

i. Profit/Loss



ii. Turnover

iii. Brokerage

iv. Net Profit/loss

v. Cumulative Profit/Loss

And the table below the back testing sheet will give over all result as shown below.

Excel sheet 7. Back testing Result for PFC Selling

QTY VOL P/L Brkg Net P/L

Total Volume (Rs)

2,68,000 3643700 653420 8967 644453

Max Profit in a single trade 110500 744 110237

Max loss in a single trade -49800 54 -50544

Average P&L per Trade 15558 214 15344

No of Losing Trades 16 16

No of Winning Trades 26 26

Total No of Trades 42 42

% of Losing Trades 0.38 0.38

% of Winning Trades 0.62 0.62

Amount Lost in Losing Trades

-

2,34,440.00

-

2,38,390.12

Amount Gained in Winning

Trades 8,87,860.00 8,82,842.72

Average Loss/Losing Trades -14,652.50 -14,899.38

Average Gain/Wining Trades 34,148.46 33,955.49

Average Gain/Loss 2.33 2.28

Excel sheet 8. Back testing Result for GRASIM Selling


Total Volume (Rs) 15,000 788685 133605 2377 131228









Amount Lost in Losing Trades -72,720.00 -74,106.87


Trades 2,06,325.00 2,05,334.50






Excel sheet 9. Back testing Result for Hindustan Unilever Selling


Total Volume (Rs) 11,800 727939 128069 2416 125653









Amount Lost in Losing

Trades -56,461.00 -57,532.32


Trades 1,84,530.00 1,83,185.44




Excel sheet 10. Back testing Result for PFC Buying


Total Volume (Rs) 78,400 928014 212614 2896 209718











Trades 2,88,330.00 2,86,734.22




Excel sheet 11. Back testing Result for GRASIM Buying


Total Volume (Rs) 7,500 388208 66683 1176 65506













Trades 1,10,587.50 1,10,122.28




Excel sheet 12. Back testing Result for Hindustan Unilever Selling


Total Volume (Rs) 11,800 727939 128069 2416 125653











Trades 1,84,530.00 1,83,185.44




Data Collection

A. The Data collected is Secondary Data Mainly from two websites

i) nseindia.com

ii) bseindia

B. Data was collected from the historical data from these sources and data was collected of last 10

years

C. The selection of all three company‟s stocks were done at random.



Data Validation

From the collected data of years only that data was considered when the liquidity came to the

option market i.e. a fair amount of open interest were there in the market.

Secondly option data of current month expiry of last four days were filtered because of the delivery

settlement of the assets were made compulsory and therefore many brokers don‟t allow trading in the

last four day giving us incorrect Implied volatility (IV).

Note: There were some days where certain data was missing in historical option data resulting the

IV to be zero for that day, such days were ignored while selecting the Extremes.

Conclusion

Derivative trading strategy developed during the research if all rules are applied it can give us a lot of

profit for all the three stocks and hence I am concluding Null Hypothesis has been Accepted and

Alternate Hypothesis has been Rejected.

Limitation

1. With this Strategy we get very few trades around 2-3 trades only in a year per stock.

2. There is a possibility that there are some early losses in some first few trades itself so one should have

capacity to bare such losses early in the trading so than he/she can benefit from it later.

3. If there is a stock split in the future the extremes could change and we have to wait before we get some

year‟s data.

References

1. https://corporatefinanceinstitute.com/resources/knowledge/valuation/option-pricing-models/

2. https://www.barchart.com/education/options-education/values

3. https://www.investopedia.com/articles/investing/021716/strategies-trading-volatility-options-nflx.asp

4. https://www.jstor.org/stable/2327127?seq=1#metadata_info_tab_contents

a. https://www.academia.edu/33903841/THE_GREEKS_and_BLACK_AND_SCHOLE_MODEL_TO_E

VALUATE_OPTIONS_PRICING_and_SENSITIVITY_IN_INDIAN_OPTIONS_MARKET

5. https://www1.nseindia.com/

6. https://www.bseindia.com/



https://corporatefinanceinstitute.com/resources/knowledge/valuation/option-pricing-models/

https://www.barchart.com/education/options-education/values

https://www.investopedia.com/articles/investing/021716/strategies-trading-volatility-options-nflx.asp

https://www.jstor.org/stable/2327127?seq=1#metadata_info_tab_contents

https://www.academia.edu/33903841/THE_GREEKS_and_BLACK_AND_SCHOLE_MODEL_TO_EVALUATE_OPTIONS_PRICING_and_SENSITIVITY_IN_INDIAN_OPTIONS_MARKET

https://www.academia.edu/33903841/THE_GREEKS_and_BLACK_AND_SCHOLE_MODEL_TO_EVALUATE_OPTIONS_PRICING_and_SENSITIVITY_IN_INDIAN_OPTIONS_MARKET

https://www1.nseindia.com/

https://www.bseindia.com/

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