Every once in a while, there comes a highly consensus-driven move. Last week’s move was no different where everyone believes the only direction is downward.
The fact that this consensus does not agree with the proceeding medium-term up move creates unrest in the minds of traders.
This unrest driven by consensus more often than not ends up amplifying the effect of the development and adds fuel to the ongoing volatility.
By the virtue of being trend followers, we shall never question the price action. But, at the same time it is equally true that the market never rewards consensus.
One should not start taking contra bets aggressively as it is a classic case for creating a hedge. Taking a ‘hedge’ is most ideal and shall be inculcated as a natural instinct as and when there are extremes.
Extremes could be at both the ends. It could be extreme fear (would kind of come naturally) or extreme greed.
Fear, I do not want to elaborate as any prudent trader would like to have a known loss strategy in times of extreme pessimism, but paying that extra cost especially in the times of downward moves is a bit much especially when the premiums have ballooned up to very high levels.
It is empirically proven that the house always wins, hence in most of the pessimistic times, there is always a possibility that while the entire participation is in the sell mode, the market could have something entirely opposite planned for us.
Let’s answer — how to trade contra?
The best possible solution is to have a synthetic call in a place where one goes long on futures and buys a Put of a strike slightly lower than the current market price.
This looks like a Call, feels like a Call but it is not a Call. There are two reasons for resorting to synthetic calls.
1. The losses are defined by the virtue of long put which can be adjusted fast as the in case we go right the Put is always going to out of the money and would typically have more liquidity
2. More often than not when a bounce comes the option premiums drop and due to very nature of the implied volatility behaviour distanced Put would not be affected much due to the fall in implied volatility
One more way to take this kind of contra trades is by deploying an ‘Out of the Money’ Call Butterfly. OTM Butterfly Spread is a moderately bullish strategy when executed with higher strikes than the current market price.
It offers decent reward-to-risk at a low cost. In this, we sell 2 Calls close to the expected level on the higher side and buy equidistant Calls one on the higher and one on the lower side of the strike sold. The maximum profit is made if the stock/index closes at the strike of the option sold.
The first reason to do this strategy is that Butterfly offers typically phenomenal risk-reward and most of which are unachievable in any spread strategy with no net options sold. Secondly, Butterflies are the cheapest to execute.
The only issue is that if there is move too soon trading profits could be minuscule, hence, one needs to do a tiny adjustment here, try and keep the difference in the higher strike sold lower than the lower strike so for example if my for a INR 100 my target is 110, I would execute following:
Buy 105 CE, Sell 2 Lots 110 CE and Buy 112.5 CE
This will make sure that there is a profit even if the stock overshoots my target by paying a bit extra cost as this would cost more.
These are just a few examples but an attempt with limited and small risk and the open upside is a must for taking any Contra Trade.
(The author is CEO & Head of Research at Quantsapp Private Limited.)
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