A market, such as the current one, evinces low conviction. After bottoming out following the fall, the upmove has taken its course. These are no more termed ‘bargain hunting’ days. Rather, this ongoing rise still seems shaky and shows the possibility of fizzling out and resuming the fall again.
Most of us do get presented with such situations of bias some time or the other. These are the times when we have very low conviction on the upside as well as on the downside. Now, despite expectations of consolidation being ruled out in most of these cases, we would still want to make trades.
One way many of us handle this is by keeping a mix of both Buy and Sell positions in our trading portfolios. However, that may not be enough, because any big move in one direction may end up nullifying the profits made against losses incurred in the unfavourable trades.
The best way to deal with this, that I can think of, is via a trading mix of OTM (out of the money) Vertical Spreads. Let us understand this better.
- a) OTM: Strikes chosen are either higher Calls/ lower Puts compared to the current market price
b) Spread: Buying one Option and selling another Option of the same stock
c) Vertical: Both Buy & Sell Options belong to the same kind (Call/ Put) and same expiry.
Stock X Trades @100
Call OTM Vertical Spread (To trade bullish view)
Buy 105 June Call @4
Sell 110 June Call @2.5
Put OTM Vertical Spread (To trade bearish view)
Buy 95 Put @4
Sell 90 Put @2.5
Premiums are kept same for ease of computation
Pay-Off
Maximum Loss: Net premium paid (higher Call / lower Put sold will command lower Premium) = 4-2.5 = 1.5
Maximum profit: Difference between strike – net premium paid = 5-1.5 = 3.5
Now consider two separate trades with the same examples put across above. If we have Call OTM and Put OTM Vertical Spread as a mix of long and short trades, and both stocks move up by 10 percent.
Net Result
In Futures
Long stock @100
@110 profit = 10
Short stock @100
@110 loss = 10
But with OTM Vertical Spreads
Call Vertical Spread @100
@110 Profit = 3.5 (On expiry)
Put Vertical Spread @100
@110 Loss = 1.5 (On expiry)
In Futures long & short portfolio = + 10 – 10 = 0 (no profit, no loss)
In Options long & short portfolio = + 3.5 – 1.5 = 2
Thus, OTM Vertical Spreads are the best to tackle a trend dilemma like this. But, if this is so great, why are people trading futures?
The downside to trading in OTM Vertical Spreads is that if the stock remains at 100 at the end of the expiry, we end up losing Net Premium paid (1.5 + 1.5 = 3) on both Call & Put OTM Vertical Spreads. Chances of this happening are slim, but the possibility exists.
Hence, we should keep in mind
- A mix of Call & Put OTM Vertical Spreads should be executed only when there is complete dilemma on the trend.
- If at any time, we get a feeling that stocks or indices are getting into a consolidation mode, it’s best to get out of all the spreads.
Believe me, losses will be far less than the maximum loss of 3.
Every comfort comes with expectations of our being responsible. As long as the aforementioned two points are kept in mind, we would not lose money to low conviction.
Disclaimer: The views and investment tips expressed by investment experts on Moneycontrol.com are their own and not those of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.
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