How to trade options when bottom is too far away and expected room at the top: Shubham Agarwal

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The rally amid the COVD-19 outbreak has bedazzled many. While the mechanics of it is beyond the scope of this discussion, there still is a fact that every trade taken with an increment in prices adds some amount of scepticism or apprehension.

This scepticism could very well be because the market is able to foresee and discount something that we do not have the vision for. Nonetheless, one thing that does come along with it is lack of conviction. The current situation is not all that different.

With a significant rise from the bottom of the year, many of us could be dealing with similar conviction issues at least before taking a long trade. I firmly believe trading in options could easily help in dealing with it.

Consider the recent situation where after hitting a high around 10,500 Nifty went into a tiny pull back for a few days. Right after that just in a couple of upticks, we cleared the previous high and there was straight forward momentum.

This kind of straight forward rise could be traded with ease using options, where a time-bound long call option trade does the job well. We safeguard ourselves from the risk of a big drawdown at the same time the trade would be able to bank on any significant move up.

However, the challenging time is the one after the recent sprint. More often than not, a pullback or a consolidation could be in the offing.

Let us see in situations like these how can we use options to get the best out of the expected move at the same time avoiding any big loss.

Best way to deal with this is to create an OTM vertical spread. Whereby a 2 step out of the money option is bought, Call in our case. Alongside just go at least 2 to 3 strikes further up and sell one lot.

These vertical spreads will take care of two things. Option bought and sold will take care of the fact that no matter how long we stay in the trade to a certain extent the time value is always being funded and in case the option premiums were to come down with market wide drop in risk premiums, we are immune due to a spread.

As far as trade is concerned, stay long enough and all we lose is the net premium paid, but in case of a sufficient move up, at times the pay-off could be more than 3 time the premium outflow at stake.

Vertical spreads do take care of the fears of consolidation or pull back but on top of that there could be those tickling sensations that could get created where let us just say after spending some time around current already elevated levels, there is yet another expectation of a breakout.

Considering that the risk premiums would already have taken a beating by now, the options generally in such situations would be relatively inexpensive. Here a possible make or break situation could be traded by taking a strategy route instead of just a single option. The trade would still be time-bound.

The strategy one could deploy is Back Ratio Spread, where we sell one lot of Call around current levels and Buy two lots of two steps higher Call. The trade keeps the upside wide open and is generally well funded but it has to be closed in one – three sessions, else the time value decay of two lots would come to bite. On the other hand, if that violent move did come up. The loss on one option sold gets covered by one bought option partially while the other buy starts making money.

The good part of this strategy is that in case if there is a break scenario in this make or break situation then all at stake is the net premium paid. The only thing that could kill this trade is if a consolidation sets in. We deal with that using time stop loss.

So, these are a few ways to trade an already risen market with ease and comfort equal to that of a market set-up that is close to a bottom.

The author is CEO & Head of Research at Quantsapp

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