Waiting to buy during a correction? How about making additional returns from this 'intention'?

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Market

In this article today I’ll talk about simple yet not often practiced trades where investors can use options to add returns. It is generally assumed that options are an instrument for active traders but in reality, using options along with investment portfolios can help amplify returns.

In a rising market, many investors wait for corrections to participate but at times the market keeps going higher, leaving the investors out and despite the intention to buy lower, they miss out on making returns from this intention. This intention can be used in the options market to create additional returns.

Say an investor is waiting for a correction to build a five-stock portfolio and one of them is SBI. SBI recently corrected from Rs 430 to Rs 360, that’s a healthy correction of 16 percent but you are comfortable buying it at Rs 335, which is another 7 percent correction. This means that I have funds with me waiting to be deployed but unless the price comes to Rs 335, I will not be able to participate and make any return.

Now, using this intention I can make additional returns by selling 335 Puts. The price of 335 put is 6.2, which compared to the strike price of the buying intention is a return of 1.85 percent p.m. (6.2 / 335). This means that if SBI doesn’t come to 335 for a year and I keep selling the puts every month. I will make around 22 percent return without even having to take any actual trade on SBI. The actual money which was waiting to be deployed might have been lying in a bank FD making additional interest income. Isn’t that awesome? Let’s master the action plan.

Scenario 1: Instrument does not drop to the intended buying price

If the market is in a strong uptrend and there isn’t any pullback in the stocks you wish to buy, then just selling the puts at the price of intention (assuming the intention of buying in 7 percent-10 percent pullback is active) can make you returns of 22 percent as in the above SBI example plus additional FD returns where your money is parked waiting to be switched. Even if you pay a 30 percent margin still 70 percent of the capital can be kept in a bank FD.

Assuming FD provides 6.5 percent interest that a net return of 22 percent + 6.5 percent * 0.7 = 26.55 percent p.a. (Note, the premiums can be different for different stocks and at different IV levels for the same stock). If you do not wish to buy on a pullback, or you feel the stock is too expensive, you can simply stop selling puts in those expiries.

Scenario 2: Instrument corrects below the intended buying price

Now, whenever the instrument price corrects below the buying intention price (which was Rs 335 in the above example), till this happens we have been making returns and even if this happens in the first expiry itself still below is my payoff.

Credit from selling 335 PE: Rs 6.2

Buying Price: Rs 335

Net Buying Price Rs 328.8

So even if the price comes down, you still get an additional discount in the buying price to the extent of the premium received which is 1.85 percent.

Summarising the above two scenarios, you make additional returns in the above example of 26.5 percent p.a. if the stock doesn’t correct or even if the stock corrects, you gain a minimum discount of 1.85 percent in the first trade itself. That’s how you convert your “intention” to money.

Let’s talk risk

So what can go wrong? If you had the intention to buy the stock, there is nothing is wrong with the options trade but if your intention changes, then there could be problems.

After selling the options now you are bound to buy the stock at that strike price on expiry, else you can have losses in your options trade . So, the above strategy should only be executed where there is a strong intention to participate in the correction.

If your view changes on the stock and you do not wish to participate, you should not sell the puts in the first place or exit before the stock corrects.

Note, these trades will get converted only on expiry days and interim corrections will be difficult to grab. On expiry day as your sold put expires in the money, you will automatically receive underlying securities.

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