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Chasing big run-ups effectively with option spreads: Shubham Agarwal

There is a bright possibility that straight forward single option or a future could get a rather unpleasant early exit.In case one is ready to hold the draw down(maximum notional loss posted) would keep the profile of the trade rather unattractive.

SHUBHAM AGARWAL | 20-Jun-20
Reading Time: 3 minutes

It is becoming more of a trend for the market to have indices loiter around the round figure levels like 9,000, 10,000 etc. for a while and then take a sprint. Worse part is that nowadays it does not stop at one, there are series of sprints that ends up pushing the index to yet another round figure for the index to loiter around and digest at.

Often times 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 rather choppy market with larger degree swings than the usual.

After being left out in the last run now we would look at first one of such sprints as trading opportunity but amid sprints we would face one of the two difficulties,

1. Getting stopped out before hitting the price objective

2. Trading with an excessive leeway in terms of stop losses creating a deep draw down trade.

Either of the cases ruin chances of making money despite of the fact that the view was right. To add to this these are the times when every bit optimism or pessimism gets priced in emphatically. This means that over reaction to could be so fierce that a rise could be followed by a big gap down reversing 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 straight forward single option or a future could get a rather unpleasant early exit. In case one is ready to hold the draw down (maximum notional loss posted) would keep the profile of the trade rather unattractive.

The solution that I reckon resorting to always is out of the money OPTION SPREADS that takes care of the draw down as well as the Reward to Risk. Regardless of longevity of the move or the implied volatility (expensiveness) of the options one can utilize this trade.

Although this trade hold 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 a small addition. The trade we are going to discuss is Out of the Money Vertical Spread.

The actionable here is pretty simple we buy an option of two to three steps out of the money strike Higher Call and go a couple of steps further out of the money (higher strike) and sell same quantity same expiry Call option.

What this would do is fund the higher premium Option Buying with a higher Premium option Sell. Now typically the spread i.e. net expense would be miniscule. So the draw down is defined to that tiny expense that we have made. Benefit of this is no stop loss, we can write it off and be in the trade till the time we want to be in the trade. The stop loss exit is no longer predicated on 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 with stock at 100 I Bought 110 CE & Sold 115 CE, if the price were to come up to 113-115 the spread would be at least at 2.5. Funny as it is but options being scientific instrument with a no arbitrage theory in place, this equation hold good in all volatility regimes and across the expiry.

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

The author is CEO & Head of Research at Quantsapp Private

Disclaimer: The views and investment tips expressed by investment experts on Moneycontrol.com are their own and not that of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.

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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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