Yes, there are ways of funding those sunk costs that options bring along with them. While in the topsy-turvy markets they work most efficiently giving us the worth of every paisa paid for it, in times of consolidation especially after big run-ups same sunk costs of option premium bite us with every passing hour and no or adverse movement.
Let’s face it, Options are the ideal instrument to resort to in situations like today after the Nifty reversed 70 percent of the drop caused by COVID-19 and is still standing strong. There is nothing wrong in resorting to Options now considering the height, at the same time, considering the potential on the upside.
Now it’s the question of making good on 2 out of 3 outcomes after such run-ups that may bite us. Pull Back or Consolidation has to be tackled with while chasing these big run-ups. Both the situations would create a dent in Option Premium due to depleting time value.
There is a way to fund these Options that are meant to chase the Big Run-ups and avoid adversities (Consolidation, Pull Backs) created by the baggage of Big Run-Ups.
As far as trading difficulties go, there could be straight forward two obstacles standing in our way to our profit objectives:
1. Getting stopped out before hitting the price objective.
2. Trading with an excessive leeway in terms of stop losses creating a deep draw down trade.
Either of the cases ruin chances of making money despite the fact that the view was right. To add to this these are the times when every bit optimism or pessimism gets priced in emphatically. This means that over reaction could be so fierce that a rise could be followed by a big gap-down reversing in the later hours to make a higher high eventually.
These moves are capable of testing the endurance of the trade. There is a bright possibility that straight forward single option or a future could get a rather unpleasant early exit. In case one is ready to hold through the draw down (maximum notional loss posted), it would turn the profile of the trade rather unattractive.
The solution that I reckon resorting to always is out of the money Option Spreads which come with a funding mechanism that take care of the draw down as well as the Reward to Risk. Regardless of longevity of the move or the implied volatility (expensiveness) of the Options one can utilise this trade.
Although this trade holds good for longer horizons, let us try and look at it from the immediate term trade perspective as well, which could have a life of one or two days. Lower time horizon would automatically bring buying an Option to mind. Let us do that but with a slight alteration and a small addition.
The actionable here is pretty simple we Buy an Option of 2-3 steps out of the money strike Higher Call and go a couple of steps further out of the money (higher strike) and sell same quantity same expiry Call option.
What this would do is fund the Option Buying with Option Sell. Now typically the spread i.e. net expense would be miniscule. So the draw down is defined to that tiny expense that we have made. Benefit of this is no stop loss, we can write it off and be in the trade till the time we want to be in the trade. The stop loss exit is no longer predicated on price move.
Reward is the difference in strikes bought and sold minus the net premium paid. Even the reward profile is better since it is out of the money spread, would more often than not come with reward equal to twice or more that of the net premium paid.
Now considering that the expense at hand and considering the expected return in estimation, take all the trade you want to using OTM (out the money) spreads that make sense in terms of Reward to Risk profile without being worried about anything.
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.