Ratio debit spreads for bargain hunting challenges

Nifty has seen over a 1000 points fall when it hit the recent low. This makes a case for creating some sort of bottom fishing strategies. However, every time we think of Buying at make-or-break levels, we get scared. Options do help but trading in options for bargain hunting comes with its own challenges.

Let us understand the risks posed by such 2 challenges and understand how Ratio Debit Spreads can help.

Challenge #1: There is lot more fall coming (our view proved wrong).

Remember from around 21,600 onwards for NIFTY we had not seen any big fall as such that amounts to 15%20% kind of deep correction. So, while hunting for bottom fishing trades at the lower end of the recent range, we always have a fear of getting it grossly wrong this time around.

Challenge #1 can be solved by Buying Options but that brings up another Problem.

Challenge #2: What if the bargain hunting move is not enough to make money (Pricy Options)?

We all remember this characteristic where options premiums go up with fall in the underlying index or stock. This is explained by the very increase in demand of Options which are inherently capable of giving potentially much bigger rewards against a small, limited risk. While buying options for bargain hunting the max loss becomes very big due to this.

On the other hand, the potential profit reduces both in terms of percentage as well as absolute money because remember if we are right, the same demand in Options would go down pushing the Pricy Premiums back to normal. Solution is a strategy that looks a bit complicated but has very big potential.

Ratio Debit Spreads

This strategy involves Selling one Call option with strike closer to current market price and Buying not one but 2(ratio) Options of Higher Strike Call (against Call Sold). Since the options have net debit or premium to pay hence, we are calling it Ratio Debit Spread.

We do come across the time when the indices breach the rang on the lower side. This creates expectation that we may have overdone the fall. Such is the view that the Debit Ratios caters to the best. The conviction on the big move either Break down or Bounce Back is set and that too within a very short span of time.

With Debit Ratios if the market turnaround takes place one would end up making good money after a big move due to the very fact that there are 2 options bought against one sold. On the other hand, if the volatility is on the other side and if the big opposite move sets in, all 3 Call options would start reducing towards zero. This would be ok too because net premium outflow if all goes to zero is also negligible.

The net premium is paid while making the strategy (Buying & Selling options). That would be the loss if the maximum big fall comes around.

Only caution is If Volatility does not come around in next couple of days, then exit the trade. Again, the cost of carrying the trade for 2-3 sessions would not be so much. Lastly, if it’s the week of expiry then trade the next expiry.