Buy after a rise confidently with Collar: Shubham Agarwal

F&O Cues

When Indices rise big from the recent bottom it becomes difficult to build enough confidence to Buy. There are few issues with this situation.

1. What if the market pulls back?

2. What if the pullback turns out to be just short correction?

3. What if there is time correction?

All 3 of them are valid concerns and traditional trading solutions become difficult to give a right answer to it.

Market pullback and short correction can be dealt with a simple Buy call instead of Future but same does not save from time correction. While the time correction is not a problem for a future but then the unlimited (more of unknown) risk profile does not let us trade confidently relaying only on the stop loss mechanism.

Solution is a strategy called Collar -

Buy Future

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Buy Put Option (Strike close to current market price)

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Sell Call Option (Strike close to short term target Price).

It is a self-healing strategy both in terms of limited loss as well as protection from time related loss in option premium.

This example shows the pay-off diagram.

As we can observe the first thing is the limited profit profile of the strategy. Considering we have a situation where we have already gone up significantly, it makes sense to have that compromise.

Second thing that may not be noticed right away but could create a bit of discomfort is that the max profit and max loss both of the strategy is far lower than that of a future.

With this kind of strategy, the spread margin benefit will help get the entry at a very reasonable margin. This will help justify the smaller profit. I am sure no one has a problem with the smaller loss.

Any option trader may also pick this up from the pay-off profile is that the chart looks very similar to a Bull Call spread, where one Buys a Call and Sells a higher strike call. The pay off is similar but the strategy of Collar is lot more flexible when it comes to the instruments. We can see this when it comes to the management and exit strategy.

What to do once we are in the trade?

Bull Case:

If we get the trend right and the underlying stock or index does go up, then book it like any other trading strategy once the desired price target is achieved. The grey line in the graph shows us the profit or loss if the underlying moves up or down during the expiry.

Bear Case:

If the underlying start moving down one is expected to take an exit once the view of bullish outlook is invalidated. In case if it does not. Just stay Put.

Best use of this trade for me has come when a fall comes right after my execution. I usually book profit in the Put bought and Buy another Put of a lower strike that is closer to then current market price.

Neutral Case:

Passing time with no move will reduce the horizon and may reduce target as well, in such case book profit in Call sold and Sell new call with a Strike closer to new closer target.

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