Indices have been moving in a range of a few percentage points around 25000. This is the market when directional trading becomes difficult. Slow markets like these makes wait and watch the result for most of the trades.
Now that is not a problem when it comes to Futures. Remember, unlike Options, Futures are immune to the time related losses. However, the funny thing about these slow consolidating markets is that you never know when it breaks out or breaks down. So, one is always in need of protection.
Once the word protection is used, Options come into play. Simple strategy would be to just buy an Option where the protection is inherent. However, the obvious problem is to get the removal of time value related losses.
Also, once an Option is bought, that becomes the primary position. While a Future with Option as a protection is far more flexible. We can achieve the solution to time related losses with Collar strategy.
Let us first understand the construction.
Buy Future + Buy Put (Strike Close to Current Market Price) + Sell Call (Strike Close to Target Price)
Following example shows the trade on stock options.
There are a few notables here.
Notable #1: With the positions in both Buy and Sell Option along with the future, the trade turns into a spread. This will straightaway bring down the margin for the Futures trade. Which means that the investment will be lower than that of only Future Buy. It does cost in terms of margin more than Buy Future + Buy Put position. However, that brings us to Notable #2.
Notable #2: Taking numbers from this example, we can see that the premium of Put at 23.1 is subsidized by Call Sell premium by over 50%. This makes the extra investment worth. On top of that on the day of expiry the trade comes into profit much before the one with just Buy Future + Buy Put.
Notable #3: The inherent quality of trade of protecting from any big adverse move is still maintained. Maximum money lost is just INR 7 on the downside. This makes the whole trade worthwhile.
Notable#4: We do have profitability a little squeezed because of selling of the call we are not expected to make any money beyond a certain point around 1400. However, the max loss placed at INR 7 makes the profit more or less at double of that of the max loss.
Lastly, there could be arguments that Collar looks, feels and also costs just like a Bull Call Spread. It does a lot but remember the Futures trade in the equation makes the entire trade more flexible.
Slow markets are prone to slower moves and that may not even reach the target in a hurry. With Collor, Put can be moved upwards in case the Future move close to target but does not hit the target.
More importantly this is a trade that makes the directional trading possible without a lot of money at stake. So that for the same risk capital multiple trades can be taken.
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