Options have primarily been instruments of risk transfer. In other words, the instruments that can help hedge the risk of those who would want to avoid them. These hedges are often times looked at the remedy of the problem.
They do serve as a solution to stop the wounded trade from further bleeding at a cost. Here, we are not talking about the reactive hedges. The point to concentrate on is, looking at options more as an insurance and resorting to them to safeguard from any upcoming risk that could possibly make our trade bleed.
Let us start with looking at those scenarios where such insurance would be a need of the hour. Since we will be taking the proactive hedge right at the time of taking the fresh trade, it makes sense to judge all those scenarios that would advocate a proactive hedge.
Current trading landscape is ideal time to look at proactive hedge. Few of the learnings from past almost 2 decades of F&O trading data is that there are following developments that take place which not all the times but often times coincide with the tide turning and would induce us to create a proactive hedge.
1. Price-OI action: In the Underlying price action when there is a serious struggle around the top after posting a big rally. The price does not move much and OI in futures stop coming in. There could also be a reduction in OI trend.
Such times are indicative of an exhaustion and a possibility of a pull back if not reversal would always be on the cards till the underlying moves away in the direction of the preceding trend from current level advocating a proactive hedge.
2. Sentimental Indicators: Sentimental indicators are more or less mean reverting in nature. They do give away a decent insight of over optimism in a rally and over pessimism in a fall. IV and Open Interest Put Call Ratio (OIPCR) are two such indicators that one could look at.
a. IV: Implied volatility generally gauged using a proxy of India VIX for Nifty IV would drop down amid a rise. A multi-month if not multi-year low should set an alarm off that the ongoing rally may have done too much. Similarly, a notable high after the fall could trigger the same for a respite if not reversal.
b. OIPCR: OIPCR too works in a similar mean reverting fashion but here a notable high in OIPCR after a rise or notable low in OIPCR after a fall may put the ongoing trend in danger.
3. Trade Against the Tide: Last one is pretty simple. Not a development but a choice that we make of a trade is directed towards the opposite side of ongoing trend then a proactive hedge is a must.
Given the fact that we figured out the when to resort to proactive hedge, now there is a simpler question of how. Two of the simplest hedges for fresh trades that one may resort to are single options or synthetic options.
Single Options: Buying a Call instead of a future at the top is a simplest way of making a proactive hedge as by the virtue of buying an option one would get a natural hedge against any ugly downside. Same can be done by buying a Put instead of selling a future.
Synthetic options: Here at the top we can create the same long Call but by buying a future and at the same time buying a Put option.
The pay off is the same but in this synthetic Call many traders keep modifying the strike as the trade moves in favor and use this as a trailing stop mechanism without disturbing the futures position.
Finally, using the proactive hedge is important as by doing this one will never miss out on any possible move due to lack of conviction and courage as the hedge would adjust and reduce the risk at a tiny sunk cost.
When market or stock at top. Ivs at bottom, oipcr at top
Against the tide trade
Single Call … naturally hedges downside
Futures + Pu.. Synthetic call
Existing positions blanket cover.. Index hedge
(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.