Deploy ITM Spreads for expiry week trading

We are now in final expiry for 2024. Nifty is trading lower for the month. However, seasonal returns for the index have been positive. Looking at this many of us could get tempted to take a bargain-hunting trade in the final week of expiry.

Since it is a low conviction and against the trend trade, one would for obvious reasons go for an option trade.

However, trading options in normal weeks and the week of expiry are completely different things. There are 3 things that one has to take care of, which are the following.

1. Fast reducing Time Value

2. Reducing the sensitivity of Higher Calls and Lower Puts (Cheaper to trade options).

3. Inability to define a stop-loss in Option Premium

All these 3 difficulties can be cleared by taking one simple trade in the week of Expiry.

Trade: ITM Spread

ITM: Lower Strike Calls and Higher Strike Puts compared to the current market price are called ITM Strikes.

OTM: Higher Strike Calls and Lower Strike Puts compared to the current market price are called OTM Strikes.

Spread: Spread is a strategy that involves the Buying and Selling of Options of the same stock. The Strike prices are usually different with the same Option type (Call or Put).

In the ITM Spread strategy that we are referring to, one buys a one-step ITM Option and Sells a one-step OTM Option.

Why Do This?

Fast reducing time value negatively impacts an OTM but it positively impacts an ITM Option. Here by buying ITM and selling OTM, we are making a favourable use of the time value reduction characteristic of the Options.

The second problem is also solved because the sensitivity of ITM Options is very high. On the other hand, the OTMs who are losing sensitivity to the move in the underlying stock/index are sold which benefits us.

Lastly, since this is a spread one would not require keeping a stop loss. The maximum loss will be known at the beginning which is the net premium paid.

Maximum profit will be the difference between the bought and sold strike minus the net premium paid.

Now, we know the risk as well as the expected reward. This can help us decide whether to do the selected strikes or not. If the risk and max profit are not up to the mark, then one can change the strikes to bring it closer to the expectation.

Example: RELIANCE @ 1218 (on 20th Dec). Assuming 3 days off, we check Bullish ITM Spread’s expected performance after 3 days on the day of expiry.

The chart shows ~9000 in max profit and ~6000 in max loss. This is 1.5:1 Max Profit: Max Loss. This may look a little disappointing on the face of it. However, no one takes stock options to expiry due to the physical delivery obligations. So, whoever does the trade and exits before the expiry even at a lower level of let’s say 1200 or 1190 also may not lose as big as 6000.

The best way to trade expiry weeks is with OTM Spreads both bullish and bearish.