3 best strategies when market trend is unclear

Buying options may lead to many small losses but a few big profits as well.

The equity market often enters a phase when the trend is not clear, especially when a robust, growing market falls big, similar to what is playing out right now. The Nifty fell from a high of over 20,200 to around 18,800. The fall has not extended but neither is the index on a rising spree.

These are the times when trend-following systems struggle. Many traders choose to pull out, at least partially, till the confidence returns. However, with options, one is very well-placed. Remember, option buyers are used to being wrong a lot of times.

Let me explain, but first, let us look at a few known observations.

1. There is evidence that most options expire with zero value.

2. Time is the enemy of option buyers as premium drops with the passage of time.

3. Most importantly, only option buyers have the potential to get 100 percent from their position.

These three factors are easy to comprehend and form the basis for two major conclusions:

A. Option buyers will have a fantastic reward (unlimited profit) for risk (limited risk of premium)

B. Observations 1 & 2 will lead to a very bad success ratio for option buyers.

How does this help?

In any trend-following system, unclear trends are characterised by a low success rate. When one buys options in such times, it creates the perfect combined effect.

Buying options may lead to many small losses but a few big profits as well. Unclear trends also have similar characteristics. Option buyers succeed because when they are right, a buy option trade is best placed as potential percentage returns are sizable.

Here’s an example:

Stock X trading at 1,000 has 1,020 Call trading @ 20 with 20 days to expiry.

If within two days, the stock goes down to 970, 1,020 Call would go down to 9. But if within two days, stock goes up to 1,060, 1,020 Call would go down to 52.

What this shows is that every trade taken in Option will have a better profit profile than the stock future. For the INR 30 drop, the option premium goes down by 11, but for the INR 60 rise, the option premium goes up by 32. This means you can be wrong three times with the same target and stop loss and be right just one time and still not lose money.

The biggest problem of a low success rate during an unclear trend is solved. Now, the question is which option to buy? We all know that a call option is chosen for a bullish trade and a put option for a bearish trade. Try to buy the option of the closest expiry. The last choice is which strike should we choose for this trade.

Buy a call with a strike price that is slightly higher than the current market price and a put option with a strike slightly lower than the CMP. This should do the trick.