Pullbacks are a crucial part of any rising market cycle. They have their own importance and attraction due to the fact that a corrective down move after a rise gives positional traders a much-needed opportunity to enter.
It is undoubtedly attractive to bargain hunt in a scenario like right now. The only concern is that only time can tell in situations like this that it was a right call to bargain hunt or not.
This is because the risk while bargain hunting always is that what looks like a correction from a rise may end up becoming a reversal.
This is one of the reasons why it is more of a courageous move to bargain hunt. But, what if the risk of loss due to going wrong is lowered drastically? Bargain hunting in that case becomes very easy. We all know that, to have trade with limited risk and unlimited reward, we have readily available instrument of Options.
As we all know, the biggest fear of a bargain hunting exercise is that what looked like a support may just get broken and there could be even bigger fall after we buy. With options this extreme loss scenario is taken care of.
No matter what happens, once we are ok with premium amount being our maximum loss, there will not be any more negative surprises.
However, it is not as straight forward as it seems. When we are bargain hunting with Options, we need to make a few alterations.
#1 Time taken to revert back to Uptrend again: In all practicality, we may turn around from the level where we bargain hunt using options, but it may not happen immediately.
Alteration: I would generally prefer to have a time stop loss along with a stop loss in the underlying. This means that if we do not go further down nor we go up significantly within 2 or at the most 3 sessions, it is better to get out of the position and wait for another opportunity.
#2 Measure the Size of Pull Back: If we have gone up by 50% recently and come down by just 5%, that should be treated differently from the pull back where we came down by 20% after going up by 50%.
Alteration: For the 1st case of 5% vs 50% stick to buying at the money strike Call Options (strike closest to current market price). For the 2nd case where the fall is nearly half of the recent up move from the previous lows, we are better off with buying slightly out of the money strike call (strike that is one or two steps above the current market price).
This alteration is made for 2 reasons:
1. The premium will be low so that if the pull back turns into reversal after a bigger fall our maximum loss will be lower
2. Since, we have a lot of ground to cover just to get back to the previous high, there is a lot of money to be made. So, choosing out of the money option is also okay which may not make a lot money in a small move but performs better in a larger move.
#3. Justify the Entry: Bargain hunting should be done with a rationale. The reason behind the bargain hunting could be based of any of your personal studies other than the relying on the fact that it has fallen so much.
One of the things that has worked for me is the Highest Open Interest holding Put strike. Let us say a stock trading at 100 drops to 96 and looking at the Option Chain (available on NSE web site as well as many other analytic applications) we see 95 Put Option has highest Open Interest. This could be one of the reasons for me to indulge into Bargain Hunting.Keeping the afore mentioned points in mind, Options can definitely make the Bargain hunting exercise much easier and profitable.