How to protect profits, restrict losses after rally amid a crisis

Reading Time: 3 minutes

The recent run-up during the pandemic has been overwhelming. Such run-ups are nothing new to the market after penetrating into the multi-month, and at times multi-year lows. We all need to understand that there is a peculiarity to these moves that changes the velocity of the moves.

Let us understand this peculiarity to better understand the rapid move especially upwards and put corrective measures in place to help us trade the upticks in same pace that we trade with during any other upmove that is penetrating into multi-year highs.

The genesis of the velocity we talked about lies in the preceding causes of mayhem. Everything gets discounted in prices as it is contemplated by the consensus, be it good or bad news. Now in normal situations this is what gives us trading opportunity but during systemic risks sensed by the market (market participants) these risks turn into shocks.

These shocks create a huge dent as it is human mentality to take all bets off the table when you cannot comprehend the table. So, the price drops happen just like 2008 fall from 6,000+ Nifty to 2,000+ or recent 12,000+ Nifty to around 7,500. More often than not due to availability of short selling in futures these falls get exaggerated.

Now, once the crisis problem is realised with possible solutions the correction to this exaggerated fall happens.

Hence, the velocity sets in with following 2 forces.

1. Creation of fresh Long Bets

2. Unwinding of Short Bets

These forces push the stocks and indices too far up too soon. Since the root of these moves has short covering attributes also into it, which are hollow structures in nature that needs to get addressed with corrective measures.

Corrective Measure #1: Bargain Hunting Profit Protection

As many times, the swings are short lived and the pullbacks could be frequent. In case one has taken a braveheart call of calling a bottom and buying amid pull back with a tiny stop loss in futures. Let us say that bet pays off and the trade starts getting profitable.

The moment the loss level is covered, one could add a Long Put to this trade. While the swings are very fast and frequent, time value would not be an issue but the profit protection via Long Put after the run up will make sure that there is a reward regardless of how the trade ends.

Corrective Measure #2: Defensive follow the Leader

Just extending the expectation of frequent swings or rather short-lived unidirectional moves. When we say short-lived, it in no way means that the returns are less as we have discussed the velocity would be enough to push the stocks and indices around with a decent magnitude.

Now here when an upmove is established and we are entering after that, a measure of having defense mechanism should be added to trading by the virtue of taking a Long option route rather than a futures route. Define the aggression in strike selection here.

If we catch the move too early, may be a strike closer to CMP can be selected, else farther and cheaper strike could be selected if we feel that we are a little late in entry.

Corrective Measure #3: Commitment Modifications

This is rather a summary of the whole discussion but still, it pays to reduce commitments to trade in terms of time and moves.

Keeping the trades with smaller horizons and tighter stop losses could pay-off eventually. Mentioning out of experience, this could be painful when there are those touch and go trades exiting us out of tiny stops and then performing but it does make sure that there are no big disasters which is a big possibility.

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

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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