Sensex back above 39,000: Here’s why profit locking is apt for rising market

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This discussion would have started with just one word if I had accepted a phrase that describes the opposite of ‘Hedge’. As practically what we do in hedging is restrict our losses, whereas what we will discuss today describes the ‘why’ and ‘how to’ of locking profits.

The market has picked up momentum since September. The S&P BSE Sensex and Nifty50 rose more than 3 percent for the week that ended on October 19. The Sensex is now trading above 39,000 while Nifty50 climbed 11,600 levels.

Let us address the ‘Why’ first.

In any market, but especially in a rising market we are always confronted with a situation when the price objective or target is achieved yet the profit potential has not yet exhausted.

In situations like these we want to hold on, and at the same time want to make sure that we do not lose the opportunity to book profits.

Now, traditionally there have been mechanisms where we get into to trade with double the quantity and offload half of it by booking part profit, so on and so forth.

But, what if we do not have to do this, as this part profit mechanism has two issues to deal with:

1. If the stock turns around and eventually hits the stop loss one would get nothing out of the trade.

2. If the stock goes on to hit higher levels, there will always be lower profits as a part has already been booked.

I just want to prove that there exist profit locking mechanisms but it involves a cost. Not to forget the capacity to create double the position is also required. Instead, use options and insure it by buying a compensatory Put alongside it.

Always remember that a compensatory position added to any existing trade to aide profitability will always come at a cost and it can only restrict negative impact and not reverse it. This can work not only on existing, but also on future trades.

On existing trades, this compensatory trade would occur when we are sitting on profits right now. In that case instead of mulling over whether or not to book profits, take a cost to create an opposite position in the option and sit on it keeping the upside open at the same time locking accrued profits.

On future trades, not many of us resort to hedge because of the very first characteristic, it comes at an irrecoverable cost. Even so, have a big heart and create a trade with a hedge alongside to safeguard the future.

The benefit is very simple our maximum loss is defined hence just track profits, do not track losses.

Now comes the answer to the question ‘How’?

To create this compensatory position, it is ideal that the stock is trading in Futures and Options so that position sizing does not have an issue and the very fact that we are not creating ‘Profit Locking Trade’ in the same underlying than any other correlated underlying.

For locking profits, use options (buy Put for long futures and bought stocks, Call for short future) most of the times the cost of profit locking wouldn’t go beyond 3-4 percent even if the option is kept for a good 20+ sessions. I have always found prudence in choosing the strike to close the current market price.

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