Many times, after a large trend has gone by there comes a period of pullback from that trend or just plain old consolidation. These are usual scenarios and we have been behaving that way lately - Nifty has cooled off from 18,400 in last few months.
The recent few weeks though have been a little peculiar in nature where Nifty has been moving in big gyrations, trying to recover and get back on track then giving up. The moves have also been relatively large on daily basis. However, if we see total change in Nifty for December, so far it is almost 0.
In consolidations, especially such choppy ones, that we have been witnessing for around three weeks now can create misleading signals. However, in times like these when the patience is tested Out of The Money (OTM) Vertical spreads could come in very handy.
The difficulty of being stopped out in an unfavorable gyration is the most painful especially when after being stopped out just because of that temporary move the trade ends up becoming a winner.
To avoid this should we not be keeping Stop Loss?
Absolutely not, on the contrary, every trade in these kinds of undecisive times should have a known loss strategy in place. That is where the vertical spreads come into play.
Vertical spreads can be devised by Buying a Call/ Put Option and Selling Higher Call/ Lower put against it. Maximum profit in Vertical Spread is Difference between the Strike bought and Strike Sold minus Net Premium Paid. Maximum Loss is Net Premium Paid.
In consolidating times especially, the choppy ones, while the stronger names would also weaken, or weaker names would also Strengthen but with lower intensity. All we need to do is that when market forces are pushing our trade into an unfavorable territory, we shall have a mechanism that lets the trade weather that and survive to reap the benefits of favorable move when the tide turn.
Here Out of the Money (OTM) Vertical Spread can come in handy. OTM Vertical Spread are devised by creating Buy position of the Spread in Higher Call/ Lower Put and Sell position in further Higher Call/ further Lower Put.
Now with Out of the Money (OTM) vertical spreads we initiate Buy position in a Call or a Put a little distant from current level, meaning a relatively higher Call/ lower Put is bought. Due to this the cost of spread is lower.
This helps in dealing with the stop loss, because due to a cheaper initiation cost cum maximum loss this strategy becomes too inexpensive and hence can be kept as a without stop loss trade. So regardless of the volatility we need not exit the trade.
On the favorable side, typically whenever the tides turn and the move comes along even approaching the sold option strike the strategy pays off around 1-1.25 times the maximum loss. This may not make the profitability too attractive but would definitely raise the courage to take a trade like this.
Ideally, I would not recommend any one to take additional spreads in consolidation but lately doubling these spreads has worked for me where the half of the quantity gets booked as soon as the spread doubles and the rest is held at zero risk.
Nonetheless position sizing I would leave up to the conviction in the trade but OTM Vertical spreads are worth paying attention to as a tool to escape being unduly stopped out in violent gyrations.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.