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Use options to trade confidently at the top: Shubham Agarwal

Vertical Spreads are the easy way to trade confidently at the top. Here, for a bullish trade, buy a call and sell a higher strike call (2-3 steps away). For a bearish trade, buy a put close to the current market price and sell a lower strike put (2-3 steps away).

July 30, 2022 / 12:18 PM IST

Markets have risen in leaps and bound in recent weeks. In such times there does arise the anxiety of not being able to participate adequately enough. This, especially now with the hopes of further upside wide open. However, confidence does get shaken when we look at the fact that we are trading at the top of recent weeks’ price action.

The sharp jump in the index, of the magnitude of 5 percent, 7 percent, and 10 percent, and at such speed, does reduce confidence and create fears. As a result, we try to narrow ourselves down to absolutely high-conviction trades, leaving many other opportunities. However, with a slight modification to our trading instruments we can keep trading with the same confidence as we would have traded if we were close to the bottom and the uptrend just starting.

Let us look at two major fears that reduce confidence:

- Since the run-up, the stop losses are too far away

- Missing out of low-confidence trading ideas

Options trading has answers to all these fears and more. Let us look at one fear at a time and get the answer in terms of Options Trade to conquer that fear and boost confidence.

Close

Stop loss too far away

Well, ideally when we buy Option, we do not have such a situation of unlimited losses. So, no matter how far your stop loss is, the maximum you could lose is the Option Premium. However, considering the current scenario where August expiry has just started, and premiums are fat, we can reduce the cost by creating Vertical Spreads.

What are Vertical Spreads?

For bullish trade, instead of just buying a call, with strike close to the current market price of the underlying, buy that call and at the same time sell a higher strike call (2-3 steps away). Similarly, for bearish trades, buy a put close to the current market price and sell a lower strike put (2-3 steps away).

Example:
Future @100
Bullish
Buy 100 Call & Sell 105 Call
Bearish

Buy 100 Put & Sell 95 Put

Now, how will we make money out of this? First of all, the premium profit will be very less compared to the actual move in the underlying stock or index. However, the margin required for such a trade is also very small. So, the overall Return on Investment is comparable to the move in the underlying for sure.

What about Risk Vs Reward?

Well, even though we have one Option Buy and one Option Sell, we still have the impact of time value degradation in the Option Trade. However, generally for smaller moves of sub 5 percent or so, if the underlying target vs stop loss distance is two times, then the premium gain on such trade would also be two times upon the underlying reaching the target, compared to the premium loss that we could make if the underlying hits our stop loss.

Now, the good part here is that the profits and losses are small in absolute terms. Also, the margins are lower. So, we can take more trades. Also, if there are bigger moves, options trade will lose less and gain more.

The reason for this favourable risk-reward equation is very simple. Premium has very little room to fall, compared to the stock.

Most importantly, this trade has a limited loss structure. I would urge you to follow the stop loss and target in the underlying. If your desired target or accounted stop loss is reached in the underlying, exit the strategy. Staying in the trade after the stop loss is triggered is a waste of money.

Missing out on low-confidence ideas

Now the lower capital requirement in the Option Strategy of Vertical Spreads solves this problem. However, there is one more modification to the vertical spreads that I have been doing. For some trades, where the underlying has gone up by 10-12 percent, we still want to buy. In such low-confidence trades, go farther in terms of buying and selling options. For instance, for bullish trade, buy higher call of one or two steps, sell two-three steps of even higher call.

The premium outflow will be very little. Profits and losses too, will be little. I have been taking such trades when I do not want to keep a stop loss and I expect another such 10-percent move in the next week or so.

Farther strike creates lower premium expense. Hence, I can place this trade with no stop loss. Such is the way to handle the Fear Of Missing Out (FOMO) on low-confidence trades.

There you have it. Vertical Spreads, easy answer to trade with confidence at the top.

Disclaimer: The views and investment tips expressed by investment 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.
Shubham Agarwal is a CEO & Head of Research at Quantsapp Pvt. Ltd. He has been into many major kinds of market research and has been a programmer himself in Tens of programming languages. Earlier to the current position, Shubham has served for Motilal Oswal as Head of Quantitative, Technical & Derivatives Research and as a Technical Analyst at JM Financial.
first published: Jul 30, 2022 12:18 pm
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