Trade rounds of volatility with OTM spreads

Whether at the top or the bottom, equities have a tendency to move into a range rather violently before finding the next big move. That is what is happening right now. The trade between Nifty levels of 21000-22000 is definitely not letting any one of us take a clear positional view of the market.

Situations like these do present a lot of trading opportunities but two situations happen, either getting stop-loss triggered before the target or we need to forget about stop-loss and bear the risk of a big loss in case the directional move collapses.

Also, the short-term trend change can happen overnight. The move the next morning can push us out of trade with a gap up or gap down, not giving us the opportunity to even react to the change in sentiment.

The solution that I have resorted to always is a trade that takes care of the big losses as well as the stop-loss issue. Regardless of the life of the move or the volatility (affecting expensiveness) of the options one can utilize this trade.

Although this trade holds good for longer periods too 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 trade life would automatically bring Buying an Option to mind. Let us do that but with a slight alteration and a small addition. The trade I am going to discuss is Out of the Money (OTM) Vertical Spread.

Here (Out of the Money) Options = Call Strikes higher than the current market price and Put Strikes lower than the current market price.

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 very small. This solves one of the biggest problems. The maximum loss now in any case will be restricted to tiny expense that we have made after buying and selling Options.

The benefit of this is no stop loss is that 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 more dependent on the comfort of the trend and not how much money we are losing the trade.

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 130, I Bought 120 PE & Sold 115 PE at a net expense premium of INR 1, if the price were to come down around 118-115 the spread would be at least Rs 2.5. Funny as it is but options being scientific instruments with no arbitrage theory in place, this equation holds good in all levels of volatility and across the expiry.

Now considering 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 worrying about anything.