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Not sure where Mr. Market is headed? Option guts can still help you profit

Buying futures needs a surety of the direction as the payoff is linear but Options can still help you add returns due to its Non-Linear Payoff behaviour," says Shubham Agarwal CEO & Head of Research at Quantsapp Private Limited.

SHUBHAM AGARWAL | 17-Feb-18
Reading Time: 3 minutes

Often we could see the market trading in a shrinking range and expect a breakout but not sure of which direction i.e. bullish or bearish.

Buying futures needs a surety of the direction as the payoff is linear but Options can still help you add returns due to its Non-Linear Payoff behavior.

Options has several sweet-spots for trading and one of them is when the instrument is expected to move quickly (often within 2-3 days) for a direction and the existing volatility is low.

At such times, gain from the Greek component of Vega dominates the Option Pricing over a Theta loss. However, more the time to expiry, slower is the Theta decay and lower the hit of the profit & loss curve.

How to identify an Either-way Breakout Opportunity?

Indices/stocks normally witnesses a behaviour of a temporary halt after a strong directional move and before the trend continues. The trading range shrinks day by day into a visual technical pattern of Pennants/Flags etc.

These patterns can help you identify the breakout point. As the price moves more towards the apex, higher is the probability of a breakout either ways.

Trading one of the direction comes with a 50 percent probability and is no good whereas taking a forecast of Eitherways movement can add to some profits and Guts is a trade to get into.

What is Guts?

Guts is a 2-Legged Option Strategy which helps you make money from sudden movements in the Underlying which could be instrument soaring up or plummeting down. It’s a limited risk strategy, as only buying of options is involved in the trade.

To execute a Guts, 1-Lot of In The Money Call option needs to be bought along with 1 Lot of In The Money Put option with the same expiration.

The profit potential is unlimited and loss is limited to the premium paid. The disadvantage of executing a Guts could be a large Initial Premium outflow as both the options are In The Money.

When to Enter Guts?

A Guts can be opened with the three-step check:

1. If the Technical patterns move to the apex and breakout is expected as fast as within 2-3 trading sessions

2. At The Money Implied volatility is relatively low (As buying two options means buying volatility, no matter it’s a Call or a Put)

3. The expiry of the instrument has ample time to avoid exponential Theta decay. If not, Next Expiry can be looked at for a Guts to avoid significant Theta loss.

When to Exit Guts?

A trader should exit the Guts within 2-3 trading sessions no matter what the outcome is. If the move materialized fast, the strategy will make money from instrument going up or down.

Whereas on the other hand, if the move did not take place, the Theta loss will start hitting and a Time Stop Loss of 2 days can be extremely helpful.

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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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