Over the course of last decade, F&Os have gained multifold significance in the market. The impact of each activity in the F&O segment does leave its lasting impression on the price of the underlying.
One such activity on the open interest front is short covering. Short covering is an open interest activity where there is a reduction in open interest and a rise in price. The genesis of this activity is into the very characteristic of the F&O segment that allows participants to sell what they do not hold by short selling futures on the underlying.
Now, in situations where the tides are turning, often times there would be a set of such short sellers in futures that would be coming down in the market to buy back their futures. In other words, they wish to cover their shorts. This results in amplification in the rise in price of any underlying.
Such short covering moves, while evident by looking at the Open Interest tally (publically available information), are very luring as an initiation of fresh buy and would always have less fiercer impact on the underlying price than the hasty buy in an attempt to cut the losses.
There are strategies to trade these moves as well. First of all, treat these kinds of moves as respites. This is because as and when the short covering is complete, the stock would likely collapse. Such moves are often short lived as well.
So, the first alteration to trading these kinds of short covering rallies is to reduce the horizons of the trades. This would bring the commitment level to the matter of a couple of days if not hours. This will safeguard against any abrupt end to the short covering rally.
The second alteration is a by-product of the first one, the vehicles chosen to trade these moves shall be fairly agile and sensitive. In other words, more sensitive instruments like long futures or long calls shall be resorted to instead of spreads. This is to keep the positions easily turn into profits as soon as there is a small move in place.
On existing trades, create a compensatory trade when we are sitting on profits. In that case instead of mulling over whether or not to book profits, take a cost, create an opposite position in option and sit on it keeping the upside open, and at the same time, locking accrued profits.
On future trades, not many of us resort to hedge because of the very first characteristic, it comes at irrecoverable cost. Even so, have a big heart and create a trade with a hedge alongside to safeguard the future. The benefit is very simple: Our maximum loss is defined hence just track profits, do not track losses.
To create this compensatory position, it is ideal that the stock is trading in futures and options so that position sizing does not have an issue and the very fact that we are not creating profit locking trade in the same underling than any other corelated underlying.
For locking profits, use options (Buy Put for long futures & bought stocks) most of the times the cost of Profit Locking wouldn’t go beyond 3-4 percent, even if the option is kept for a good 20+ sessions. I have always found prudence in choosing the strike close to the current market price.
(The author is CEO & Head of Research at Quantsapp Private Limited.)
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