Trading Volatility breakouts trading with Call Ratio Back Spread.

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Indian equities have witnessed a lull over the last three months. There have been some movers and shakers within the market, but largely, the broader indices have been overwhelmingly quiet for the last few months.

As the saying going goes, the longer the lull, the bigger the move that follows it. Hence, expecting a big move may not be out of the ordinary. Trading Options with the expectation of a volatility breakout might be the way to go. However, it could prove to be a bit difficult given the point in time of the expiry.

While fatter premiums do not shrink really fast in this phase, the same characteristic can work against us while trading a consolidation as to buy one would be inclined to go net short on option so that passage of time does not hurt. This could just kill in case that one fine day the underlying decides to just blast off in either one of the directions.

Now, plain vanilla buying of option could be an alternative but even here there is a risk as the move could be sudden and it could be on either side. The relatively balanced odds of either direction do pose a risk that the fat premium could just get wiped off in a session or two due to a violent move in an unfavorable direction.

Also, one more thing to remember is that the risk premiums are at the lower end in such consolidating times. But they too spike up as soon as underlying stock or index posts a big move. So, one more reason to be on the buy-side of the option.

I believe this is a good enough rationale to propose a simple and apt solution called back Ratios considering 3 factors viz. state of the market right now, placement of risk premiums on the options, and the longer time remaining for the expiry.

Call Ratio Back spread is an option combination that involves Selling of 1 Lot of Call or Put close to the current market price and Buying not 1 but 2 Lots of Call or Put with lower premium (Out of the Money).

The salient features of this strategy are 1. It is Pro-Volatility Strategy 2. We are Net Buyers of Options 3. With a combination of Buy and Sell it still is a cheaper deal than any Net Option Buy Strategy.

Now, let us understand the operational element and economics of the strategy. It is easily understood that upcoming volatility (not a favorable move but a BIG favorable move) is needed to make sure we erase the loss of the sold option and start making money with the help of double options bought.

On the other hand, the same sort of big move if comes in the opposite direction. We will have all 3 options approaching 0 premium. In such a case, the maximum loss is the very tiny net premium paid to create the combined option position.

As far as the biggest caveat is concerned, the only way we would be proven wrong by the market is when our very call on coming out of the consolidation goes wrong. The underlying keep loitering around the same levels.

Even here due to the longer time left for the expiry we may not get hurt that bad very soon as the rate of time value decay at the beginning of the expiry is fairly slow but it will definitely bite us.

So, the last point in the exit strategy for this trade is that if nothing happens for 2-4 sessions better trigger a time stop loss and get out of the trade and wait for another stimulus to trade. This holds good as long as there is still half the expiry remaining.

Strategies with smaller losses and with a lower probability of big profits are the best way to handle such a prolonged consolidation phase and Back Ratios aptly fits the bill.

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