3 top options trading strategies for pullback/reversal move

FandO

Traders and trends go hand in hand. All of us meticulously identify the direction before taking trades, however, this exercise doesn’t always give a straight up or down answer. On many occasions, our analyses present us with a counter-trend move called a pullback or a respite.

Take the recent bounce back from 17,000 and thereabout in the Nifty. The move down from the highs of around 18,000 did see a slow and steady decline to 16,800. But, in the final week of the monthly expiry, there was a bounce, which could, as of now, be termed a respite as it may or may not sustain.

Many of us could have figured out the possibility of this bounce and even reduced the sell positions but unless the recovery turns into a reversal, we won’t like to commit.

Rightly so, since the recovery may end up being just a small bounce before a steeper fall. A pullback down move after a rise can pose similar challenges.

We will talk about three top options trading strategies that I rely on to get through such times. There are two key objectives while trading pullback/respite:

1 The strategy should be well-positioned to monetise the ongoing directional move

2 It should not run into big losses if the move is short-lived and big fall or rise resumes

Let us define three strategies for three different zones, taking the example of a Rs 200 fall in a Rs 1,000 stock.

In our example, after falling to Rs 800, the stock is between Rs 800 and Rs 840.

One can resort to an out-of-money (OTM) call spread (for a fall after a big rise, OTM put spread) by buying a slightly higher strike call and selling two strike higher calls (in case of puts, buy slightly lower put and sell two strike lower puts).

Since the move could be fast and big if the recovery has a meaningful rise, it will make good money as the reward in such a strategy is much higher than the risk. The loss is relatively smaller, which is just the net premium paid. This trade allows a wait of two-five sessions if the recovery is not immediate.

If we are between Rs 840 and Rs 880, the recovery (contra move) has already started and the best of the prices are already gone. This is the trickiest situation because things can go either way.

To avoid getting trapped, it is best to trade at-the-money (ATM) long option with price and time-stop loss.

With a small price target and stop loss, the risk in an option bought call in our case (put, if it is a fall after a rise) will be low. But, if neither comes, remember these are indecisive times, so avoid staying too long in the option. Trigger a time-stop loss after at the most two trading sessions. This, by far, is the least damaging strategy, well suited for least confident times.

Now the recovery is looking more like a reversal. In our example, if we are between Rs 880 and 920, we have covered a lot of ground. These times are generally characterised by two things:

1 If the preceding trend resumes, it will be too fast

2 In case recovery turns into reversal, there could be a big move and also a change in the trend

In most such cases volatility is expected. The best buy into volatility is by back ratio spread (with a time-stop loss).

Construction is simple for our example where we are betting on upward reversal call back ratio spread. If the situation is the opposite, then put back the ratio spread.

Call ratio back spread = Sell a slightly higher call and buy two lots of immediately higher call

Put ratio back spread = Sell slightly lower put and buy two lots of immediately lower put

A reversal with a bang can trigger a big up move and two calls bought against one sold will make us good money.

Otherwise, we bought two cheaper options and sold an expensive one. So if we are proven wrong and after 40-50 percent recovery the fall resumes with speed, the net premium paid will be a small cost to pay for being wrong.

If nothing happens, trigger a time stop-loss after two or three sessions and avoid trading in options close to expiry.

Finally, if the stock moves in recovery after a fall or in pullback after a rise of more than 60 percent, it may not be called a respite/pullback.

Disclaimer: The views and investment tips expressed by experts on Moneycontrol are their own and not those of the website or its management. Moneycontrol advises users to check with certified experts before taking any investment decisions.