Markets have been trading near life highs for a while now. It is tempting yet a little scary to trade these times. After such a rise a small correction can create a very big damage. The bigger picture may still not change but the trade we took thinking it was a breakout becomes a confidence breaker.
One may say at higher levels just simply trail your stop loss after a big move so that some profits are locked. But many times, such big moves may not come to lock profit either.
Most of the time when such an opportunity comes, the easy answer to avoid losses is Options. Instead of Buying a Futures contract we can go ahead and Buy a Call Option. However, when we buy options, it comes with its own set of problems.
Remember, the stock may spend more time around the same level. While trading futures this may not bother us at all. Options, on the other hand, have sensitivity to the passage of time. All of us know that the passage of time brings down the premium constantly.
However, on the bright side, the good part is that Options are more sensitive to the Price of the underlying than the Futures. Meaning, 1% move in the underlying stock or index will mean 1% move in the Futures price but the same could mean a 10%-20% move in the Option premium.
So, leveraging a higher percentage impact we can make a strategy with tactical execution that helps us trade in Options and make the most of the big move at the same time least affected by the time passage reduction in option premium.
So, imagine a stock X is trading at 1000.
Instead of buying a Futures contract, we buy 1000 Strike Call at 18
Stock goes up just by 2% to 1020. 1000 Strike Call would be at 30.
Now, we know the stock has started moving. Instead of booking Profit, Sell a Higher Strike Call say 1040 @ 10 which would have been @5 when stock was @1000
So, the trade is Buy 1000 Call @ 18 & Sell 1040 Call @ 10
Max Loss = Net Premium paid = 18-10 = 8
Max Profit = Strike Difference – Net Premium paid = 1040 – 1000 – 8 = 32
This is a 4:1 Reward to Risk. There is no need for a stop loss either.
On the other hand, let us imagine if the stop loss at 980 got hit 2% instead of 1020, 1000 Call would be @ 10, again a loss of just 8.
So, the strategy is simple. Buy a Call Option with a stop loss in the underlying, if it hits stop loss in the underlying, get stopped out. If it starts going up, roughly after covering half the distance of the stop loss, sell the Call of the strike close to the target price.
Upon target before expiry, the profit would be a little less than 32. But more importantly from here on if the trailing stop loss of 1000 hits then the strategy will still make some money. Futures will not make any money here. Also, the Buy + Sell position in Options will save the time-related loss as well.
Disclaimer: The views and investment tips expressed by experts on Moneycontrol.com are their own and not those of the website or its management. Moneycontrol.com advises users to check with certified experts before making any investment decisions.
Discover the latest Business News, Sensex, and Nifty updates. Obtain Personal Finance insights, tax queries, and expert opinions on Moneycontrol or download the Moneycontrol App to stay updated!
