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Traders could use OTM Spreads to monetize that far-fetched move

Considering the expected return in the estimation, take all the trade you want to use OTM spreads that make sense in terms of Reward to Risk profile without being worried about anything

SHUBHAM AGARWAL | 10-Nov-19
Reading Time: 3 minutes

In the past, we have seen that there comes an opportunity where the expectation gets set in for an out of the ordinary move. Back-to-back 3-5 percent move in a slow-moving large-cap stock is a good example of this.

Two things that these would bring along are Higher Implied Volatility (Expected Volatility) and choppy market with larger degree swings than the usual.

Situations like these do present a lot of trading opportunities but amid moves that could actually put us in to one of the two situations, either getting stopped out before hitting the price objective or trading with an excessive leeway in terms of stop losses creating a deep drawdown trade.

Either of the cases ruins the chances of making money despite the fact that the view was right. To add to this these are the times when every bit of optimism or pessimism gets priced emphatically.

This means that overreaction could be so fierce that a rise could be followed by a big gap-down reversing move in the later hours to make a higher high eventually.

These moves are capable of testing the endurance of the trade. There is a bright possibility that a straight forward single option or a future could get a rather unpleasant early exit.

In case one is ready to hold the drawdown (maximum notional loss posted) would keep the profile of the trade rather unattractive.

The solution that I have resorted to always is a trade that takes care of the drawdown as well as maintaining the risk-to-reward ratio.

Regardless of the longevity of the move or the implied volatility (expensiveness) of the options one can utilize this trade.

Although this trade holds good for longer horizons to equally well, let us try and look at it from the immediate term trade perspective, which could have a life of one or two days. Lower time horizon would automatically bring Buying an Option to mind.

Let us do that but with a slight alteration and small addition. The trade I am going to discuss is Out of the Money Vertical Spread.

The actionable here is pretty simple. We buy an option of 2-3 steps out of the money strike (Higher Call/ lower Put) and go a couple of steps further out of the money and sell the same quantity the same expiry, and the same kind of option.

What this would do is fund the higher premium Option Buying with a higher Premium option Sell . Typically, the spread i.e. net expense would be miniscule, so the draw down is defined to that tiny expense that we have made.

The benefit of this is that there is no stop loss, and we can write it off and still be in the trade till the time we want to be in the trade. The stop-loss exit is no longer predicated on the price move.

On the other hand, typically to judge the risk-reward, estimate the spread value to turn out to be half of the difference between strikes.

Let us say that with the stock trading at Rs 130. I bought Rs 120 PE & Sold Rs 115 PE, if the price were to come down around Rs 118-115 the spread would be at least at 2.5.

Funny as it is but options being a scientific instrument with a no-arbitrage theory in place, this equation holds good in all volatility regimes and across the expiry.

Now considering that the expense at hand and considering the expected return in the estimation, take all the trade you want to use OTM spreads that make sense in terms of Reward to Risk profile without being worried about anything.

Learn and read more about NSE India from Quantsapp classroom which has been curated for understanding of open interest from scratch, to enable option traders grasp the concepts practically and apply them in a data-driven trading approach.

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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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