There are numerous strategies out there which have been described in various books. But not all are useful to a retail trader.
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There is no doubt that the favorite market for most traders be it retail or institution is the options market. The risk profile suits the institutional investors and the returns potential is what attracts the retail trader. Most retail traders however, end up losing money more often than not, apart from an occasional winning trade.
One of the reasons is that these traders do not have a plan and the second is they have the same plan for all occasions. If they feel bullish they buy a call and if they feel bearish they buy a put. But this strategy is useful in only handful of situations. Further, markets trend less than 30 per cent of the time, most of the times it is moving in a narrow range.
There are numerous strategies out there which have been described in various books. But not all are useful to a retail trader. The high cost of trading on account of higher brokerages in most conventional broking outfits and higher tax structure in India make most of these strategies uneconomical.
A retail trader should look at some basic strategies with minimum number of legs that he or she can use on his every day trade.
The key ingredient of using a strategy is to presume what is expected from the stocks or the index going forward. View on the stock or the market is most important in deciding which strategy to use. Buying a call if you are bullish or a put if you are bearish works only if the market moves in your favour sharply. Markets and stocks generally grind their way up or down and only in few cases do they move up or down sharply. Buying of calls and puts thus does not work in favour in most of the cases.
Let’s take into consideration various scenarios in the market and look at the adequate strategies. Markets are either trending or are sideways. Various strategies need to be adopted in such situations.
Sideways or moderately bullish or bearish: Apart from a few high beta or highly volatile stocks most stocks generally move slowly. The strategy to use in case one has stocks in their portfolio or intends to take a new bet is the ‘covered call’ or ‘covered put’. This strategy is used to earn money when the trader expects slight change in the price of the underlying stock.
Suppose a trader holds a low beta or a less volatile stock like a pharmaceutical stock. If the stock is in an uptrend it is safer to opt for a covered call and if it is in a downtrend a covered put strategy should be put to use. A covered call strategy requires a trader to buy the underlying stock or future and sell an out of the money call option. Even if the stock languishes around the same level the trader will end up making money from the premium collected by selling the call option. In case if the stock goes higher than the strike price of the option, the underlying stock or the future will cover it. If the price closes lower, then the entire premium turns into a profit. Assume that Nifty is trading at 8500. A trader who is slightly bullish would like to buy a covered call would end up buying a Nifty future and sell the 8600 call. He will be capping his profit at 8600, if Nifty goes above this level, his losses in writing a call option will be set off against the profit from his futures position. In case if Nifty falls, he is protected only to the extent of his call option premium.
If one wants to protect their downside risk too, then he would create a ‘Vertical spread’. In case a trader is slightly bullish he can set up a vertical call spread, which is nothing but buying an ‘in-the-money’ call and selling an ‘out-of-the-money’ call option.
Suppose the Nifty is trading at 8450 and a trader expects that it may touch its resistance at 8600. In such a case the trader will create a vertical call bull spread by buying an 8400 call option and selling an 8600 call option. This way his profit is locked at 8600, but his downside is restricted to the cost of spread which is the difference between the prices of the two options.
There are times when market or a stock is lackluster. There is barely any movement which causes the option price to fall though the underlying stock is not doing much.
Assume Nifty is moving in a range of 8400 and 8600 just ahead of budget announcement. A short straddle can be created by selling both the call and put option of the same strike price. In the present case one can create a short straddle by selling the 8500 call as well as put option. Maximum profit is possible if Nifty closes at 8500. The trader needs to be careful in closing the position ahead of the event as markets are likely to blast away in one direction which will expose him to huge loses. A short strangle can also be created by selling call and put options of different strike prices. In the present case it would mean selling an 8400 put and an 8600 call.
How to trade a major event: Just ahead of a big event, like an election or a credit policy or a result markets and stocks tend to move in a small range before blasting away in one direction. Since the outcome is unknown the best strategy during such times is to create a straddle or a strangle.
Straddle is created by buying a call and put of the same strike. This strategy is most commonly followed by traders during Infosys results. However, as the date of the event nears, the premium of call and put both increases substantially thus reducing the chance of a profit.
Strangle is created by buying a call and put of various strikes. In the case of Nifty a trader can buy a 8400 put and 8600 call in anticipation of market moving away on one direction.
How to protect your profits: In case a stock or the index that a trader has bought moves up sharply and the trader is keen on protecting his profit, he creates a ‘Protective collar’ strategy. The trader purchases an out of the money put option and at the same time writes an out of the money call option.
The beauty of option is it allows one to be very creative, but a trader needs to keep in mind his cost of setting up a strategy. The most important reason professional traders prefer options is because it informs them of their risk and potential reward in various market scenario.