The Indian equity market experienced a volatile week, which was unnerving for investors. The market had been riding high on the confidence boost from the state election outcomes. As a result, we got a big drop on the first site of a pullback.
During such times, it becomes challenging to make investment decisions and commit to a particular direction. As a result, many investors may choose to stay on the sidelines and not participate in the market. However, by analyzing the market conditions closely, we can find ways to modify our investment strategies and improve our potential returns.
Market Condition:
• Already placed a big gain with lowering headroom with rise already in place.
• Possibility of serious pullback ruining our profit profile.
Options can come in handy when it comes to such situations of making a limited loss trade. But this is more of a conservative trade, where we could be okay with letting go of unlimited upside as well because of the rise already.
The collar is one of the most conservative strategies. Let us see how to create a Collar Strategy along with its benefits.
Construction of a Collar:
Buy a Future + Buy a Put Option (Strike can be just below the current market price) +
Sell a Call Option (Strike can be close to short-term upside target)
The logic behind this trade is making a Limited Loss + Cost-Effective Conservative strategy.
Limited Loss: Buying a Put option along with the Future will make sure that we do not have to be worried about having that big gap down. Even if we are not able to catch the fall, we can be assured of the fact that losses on Future will be compensated by profits on Put.
Cost-Effective: Since buying the Put option will cost a premium, with Collar we have a way to fund this payment. We always work with an upside target where we are okay booking profit. So, instead of keeping that level in mind, let us just Sell a Call option for that strike.
Buy Future + Selling Call = We are ready to forget any profits above that Strike price.
Selling Calls means receiving a premium. This action will help us reduce our cost of acquiring the Put option. This makes it Cost-Effective.
There are a few characteristics of Collar that one must know about.
• Since it is a limited loss strategy the margin requirement will be lower than Buying a Future.
• Also, the profit is limited to the Call strike sold. However, having a runaway rally from here is also not very likely.
• If we do not wait till expiry the profits could be lower but at the same time stop-loss loss would also be lower. Lower margins would always lead to better returns with lower profits too.
Finally, if we are afraid and do not trade, there is opportunity lost. On the other hand, if we do trade without realizing the danger there is a risk of a big loss. So, that is why the perfect strategy against wild swings is Collar.
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 taking any investment decisions.
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