A rangebound market is not a new phenomenon, yet every time we come out of one of those ranges, the behaviour of the prices is quite different than the previous one.
At times the prolonged consolidation with more emphatic boundaries makes the traders so much used to them that we get a sense of denial as the first reaction of the break beyond the range.
While trading in the range is comforting and rather risk-averse, the first trade outside of these ranges could also be equally fun and profitable. The risk remains of the validity of the move.
The breakouts are good but the aftermath of it brings along many questions on the immediate course of action.
In case of an upward breakout, for instance, tomorrow should we buy immediately? Should we wait for some consolidation to confirm if it’s a keeper? Is the tad bit softening for sure not a U-turn?
In times like these, options come in very handy. Yes, we know there is a limited loss of unlimited profit argument. It does hold good in principle for a rather medium-term trade (10-15 sessions), where the price objective is twice as far as the premium.
But when it comes to trade for a day or two one needs to see the impact of the deterioration of premium, where due attention to the downside in the price of the underlying and time comes into consideration. So, to deal with them we will discuss a couple of approaches.
One way to trade any break out is via Back Ratio Spreads. Here we sell one lot of Call and buy 2 lots of at least 2 steps higher Calls in case of trading a breakout or Sell one of Put around break-down, of a strike nearest to the current market price and Buy two lots of at the most two steps lower puts.
Back ratios a typically known for their pro-volatility characteristics. Here we have a forecast that we could have a big move in a day or two. While our directional Back Ratios benefit out of big move on only either one of the directions but in case of an opposite direction blast, we do not tend to lose.
Because in that case, all the options will tend towards zero. Since our net premium outflow is relatively low in the loss department we outperform. While the trade keeps the profit potential wide open.
It has to be closed in one – three sessions, else the time value decay of two lots would come to bite. That is the only caveat. Also, since the biggest enemy is Time value its best not to trade back ratios in the last few days of expiry.
#2 Straps/ Strips
Strap = Buy 2 Calls + Buy 1 Put,
Strip = Buy 2 Puts + Buy 1 Call,
Now, these are typically one-day trades. We closed near the day high. We still have an inclination after the trade opens for the next day towards either a continuation or reversal of the entire erratic move that happened.
This happens typically when the development takes place towards the end hours of the market or overnight and the break out happens in the gap. Whichever the inclination is taking a trade in that favor, meaning Do Strap if Bullish, Strip if Bearish. Only with one modification, the single option, in this case, would be a bit farther out of the money so Put if Bullish and Call if Bearish.
The exit strategy, well if all goes to plan and the move we are inclined towards happen, get rid of 1 Put and 1 Call and follow the staggered execution mechanism and sell a higher call to fund the time value for the rest of the holding period. If the unfavourable move happens, then the Put would more or less compensate the loss on Calls, since the failures are generally fiercer.
If nothing happens, well then time value loss on 3 options will not be a bucket load. No matter what though, get rid of at least two of three options bought by the end of the day.
Thus, instead of avoiding, with the use of options break out trading can be made profitable at the same time risk-averse.
(The author is CEO & Head of Research at Quantsapp)Disclaimer: The views and investment tips expressed by investment experts on Moneycontrol.com are their own and not that of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.