Critical times bring out core utility of options — risk management

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It is apt to talk more about Capital Preservation than Capital Appreciation amid the COVID-19 crisis. While Futures and Options have always been a fancy of leveraged traders or may I say traders, who have capacity to bear high risk, we should not forget about the core utility it provides to the Risk Averse class of traders and investors.

Going back to basics today to touch upon some of the fantastic utilities of options as an instrument that give us enough cushion in a trade to handle biggest bouts of volatility that we have passed thru. Sure, there are many Option combinations that we could discuss but many times during the crisis finding enough liquidity in strikes much farther to the current market price becomes difficult.

So, we will keep our discussion restricted to execution of single leg option. Let us discuss a couple of scenarios of recent times that could put a directional trader into dilemma of execution and could also put them into difficult situation as far as the exit strategy is concerned.

Considering we are starting with a clean slate the first thing that we are going to address is:

1. Monetising bargain hunting opportunities with risk management after deep cuts

More often than not an out of the ordinary move amid crisis like one we are in today would provide us with a set-up where one is forced to believe that enough is enough and the turned around is now. While our conviction could have more to do with personal bias, from straight risk management perspective taking a Long trade in a falling market is like trying to catch a falling knife.

Relief comes in terms of Buying a Call. Instead of Buying a stock at 100 buy a 100 strike Call. If the view is right, one would get all the benefit. But, in case things were to deteriorate further from there and worse if there is an equal intensity fall from here, all that is at stake is the Call Premium. Essentially, a cost paid to get the pair of gloves. On a later date when expiry nears the same can be converted to delivery as the storm calms down.

2. Trading daily extreme reversals

While the bouts of volatility continue there would also be the time when there are respites. Meaning, the market or any individual stock would not give up in a straight line there would be respites in store for us in between. This could be other way round as well, after a respite there could be expectation of the fall to resume. Either ways the trade is to try and catch a turn around, with an expectation of a temporary gain with a possibility of it turning into a big move.

For such situations as liquidity permits try going into farthest possible strike (higher for a Call. Lower for Put). Because these moves could also be temporary in nature and the market could be in for a leg down/up with even fiercer move, trading it with relatively out of the money options is prudent but there is a caveat while Buying Calls.

Caveat: We would need a bigger move that covers the premium meaning if we have bought 105 Call at Rs 5 then there should be visibility of having a move above 110. Reason for this is the premiums on options would fall especially when a possible respite from the fall is being traded, due to decrement in perceived risk when the underlying rises. So, the Call option in reversal would be coping up not only with passing time but falling risk premiums as well.

In first case, the trade is expected to be held for the rest of the expiry considering the premium as sunk cost hence it will not matter much.

In a nutshell, when the times are choppy it makes sense to get back to the basics and keep trading simple and economical using Single Options.

(The author is CEO & Head of Research at Quantsapp Private Limited.)

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