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Market situations: Articulating lack of conviction against lack of confidence

Option bought and sold will take care of the fact that, no matter how long we stay in the trade, the time value is being funded to a certain extent.

SHUBHAM AGARWAL | 27-Jul-19
Reading Time: 3 minutes

Conviction is a funny thing. In a market which is characterized by its highs and lows in detecting the future course of trading, a series of lower lows in a preceding rising regime makes it difficult to build conviction in creating a Buy trade.

In such occasions, calling it an end of a pull-back in a rising market or an end of respite in a falling market definitely lacks conviction.

Today, we will discuss about market situations like these and try to come to a few trading tactics that hold the confidence still high despite the low conviction.

Such pull-backs or respites are either with or without momentum. Let us discuss Option trade for either one of these situations.

Trading pull-backs without momentum:

With a lack of momentum in the market, we have the first and biggest enemy of the Options that is time. Now, the pull-back might get over tomorrow itself or it may take a week to do so. The problem is now to tackle the longer time duration to materialize the view.

So, first, let us handle the longer time duration trade. Typically, keeping a stop loss and adhering to it is a major issue as, more often than not, the reversal happens right after our stop loss gets triggered. On the other hand, keeping option premium as a sunk cost would not be too prudent either.

the easiest way to deal with this is to create an OTM vertical spread whereby a two-step out of the money option is bought, Call in case we are calling a bottom and Put if vice versa. Alongside, just go at least two to three strikes further up in case of Call and further down in case of a Put and sell one lot.

These Call/Put spreads will take care of two things. The option bought and sold will take care of the fact that, no matter how long we stay in the trade to a certain extent, the time value is being funded. And, on the other hand, if the option premiums were to come down in case of a bottom calling due to reducing riskiness in the market, we are immune due to a spread.

As far as trade is concerned, stay long enough and all we lose is the net premium paid. But, in case of a sufficient move up, the pay-off could be more than three time the premium outflow at stake.

Trading fierce pull-backs with momentum:

Such situations generally happen when we reach a make-or-break level in the market. More often than not, these are pivotal rounded-off levels in the market. Such periods are marked with a huge amount of volatility and momentum.

Typically, in a rising market, it is marked by 1-2 percent fall in the indices after a slow and steady drag or a similar magnitude of respite after slow rounds of up move in a falling market.

Here, obviously, the conviction would be low as this is a clear-cut trade against the current tide. Here, we are trying to trade the capitulation where one has a big move on the screen and looks like the turnaround is expected just tomorrow and with a bang. Often, this brings in an end to the ongoing Pull-Back/Respite.

The best way to trade these situations is via Back Ratio Spread, where we sell one lot of Call around bottom or Put around top of strike nearest to the current market price and Buy two lots of one at the most two step higher call/lower put.

While the trade keeps the upside wide open. It has to be closed in one to three sessions. Else, the time value decay of two lots would come to bite. On the other hand, if that violent move does come up, the loss on one option sold gets covered by one partially while the other buy starts making money.

Thereby, we keep the situation under control with clear visibility on the expected output in any scenario bringing in confidence.

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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.

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