The markets have been in consolidation mode for nearly four months now. Such a market attracts many traders to resort to option writing. In fact, big or small, most traders have a certain percentage of their trading portfolio allocated to writing (selling) options.
However, when a consolidation phase has been around for a while, option writers can run into certain risks. This makes them stay away from writing options. Here, we will discuss these risks as well as the best ways to handle this issue. One such way is Protected Option Writing. This can keep the traders safe and help them continue writing options till the end of the consolidation phase.
Risks
The risks that options writers could face during a consolidation phase are as follows:
1. Lower premium in farther strike risk: Thanks to the lower level of movement, option premiums with the same time left for expiry must have come down, offering the trader lower return on the margin paid.
2. Stop-loss risk: To make sense of returns, if the trader sells a Call or Put with strike closer to the current market price (CMP), there’s a higher risk of the stop-loss being triggered.
3. Breakout/break down risk: If the market stops consolidating and makes a breakout/break down move and comes out of the consolidation phase, the premiums could rise so fast that it would take away more than what the trader gained.
The answer to all of these lies in Protected Writing. This strategy involves the following action points:
Sell Call (Strike = Closest to Current Market Price)
Sell Put (Strike = Closest to Current Market Price same as Call)
Buy Call (Strike = Higher than Current Market Price, Call Protection)
Buy Put (Strike = Lower than Current Market Price, Put Protection)
Strikes closest to the CMP will always have maximum premium available for the trader to gain if the underlying does not move.
Higher strike Call and lower strike Put are bought as Hedge to protect against Sold Call and Sold Put. If the underlying gives a big move in any direction, the sold Put or Call can lose a lot more than the premium received. This way the losses will be controlled.
Now, if there is a big move, the loss in Sold Call or Put (beyond a point) will be protected by the profit made in the Bought Call or Put after the underlying crosses the Bought Strike.
To buy the higher Call and Lower Put, there’s a simple math. Add the premium collected by selling the Call and Put. Add it to the sold strike to arrive at the higher Call strike and subtract from the sold strike to arrive at the lower Put strike.
Here’s an example:
Suppose the trader sold 100 strike Calls and Puts for Rs 2.5 each. In that case, the trader would be buying 105 Calls and 95 Puts.
Max Profit: Net premium received after all the Buy and Sale of Options
Max Loss: The difference between the Bought and Sold Strikes (Rs 5 in this example) – Net premium received
Exit strategy: It makes sense to review and exit if the CMP of the underlying stock or index reaches one of the bought option strikes (Put or Call).
However, since the trader is protected, there’s the liberty to wait for a few hours or a day because the maximum loss in this case is defined and known.
When a trader writes options in a market with many days left for expiry, and where consolidation has been going on for a few weeks, Protected Writing becomes a sine qua non.
Disclaimer: The views and investment tips expressed by experts on Moneycontrol are their own and not those of the website or its management. Moneycontrol advises users to check with certified experts before taking any investment decisions.
