Trading expensive options amid COVID-19 uncertainties - here’s what you need to know

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COVID-19-led lockdown is prudent and apt to indicate the depth of the issue at hand. The operational risks amid lockdown are making things tougher.

This has brought us into an out of ordinary, once in a lifetime set-up where the option premiums are higher than ever, liquidity and participation have hit its lower extreme.

Building directional conviction in this situation is really hard as the data in such circumstances gets reduced to a news flow item just like any other update losing most of its forecasting significance.

None the less, we as traders do find opportunities to trade extreme opportunities. What I mean by this is that the market suddenly showing mid-day turnaround after just touching a multi-year low or sudden improvement in global scenario in our closing hours.

The source of trade could be any but the conviction is always going to be low considering the lack of reliability of the stimulus of trade. Today, we will discuss market situations like these and try to come to a trading tactic that helps you keep your confidence high despite the low conviction.

Such situations generally happen when we reach make or break level in the market which could be characterised by back-to-back deeper cuts pushing the Nifty to a previous top or tiny amount of respite from a previous low.

On the other hand, the situation could be another way around, where the previous low made in a panic has now just broken again making the possibility of a fall apart and mass stop losses to trigger.

Even here initiating a Sell trade at such a low level would definitely lack conviction.

More often than not, these are pivotal rounded off levels in the market. Such periods are marked with a huge amount of volatility and momentum.

Biggest notable on a possible bottom calling or a fresh break down trade amid this news-driven market set-ups is that the mistakes could cost us dear especially when there is a lot of time for the expiry to get over.

This along with super high implied volatility , like right now, makes it extremely difficult to trade in options due to the fat premiums and thereby larger drawdowns.

The best way to trade in these situations is via ‘Back Ratio Spread’, where we sell one lot of Call around the bottom or Put around break-down, of a strike nearest to the current market price and Buy two lots of one or at the most two steps higher call/ lower put.

The Back ratios are typically known for their pro-volatility characteristics. Here, we have a forecast that we could have a big move in a day or two.

While our directional Back Ratios benefit out of a big move on only either one of the directions but in case of an opposite direction blast, we do not tend to lose.

Because in that case, all the options will tend towards zero. Since our net premium outflow is relatively low in the loss department we outperform. While the trade keeps the profit potential wide open.

It has to be closed in one to three sessions, else the time value decay of two lots would come to bite. That is the only caveat.

Also, since the biggest enemy is ‘Time Value’, it is best not to trade back ratios in the last few days of expiry.

Thereby, we keep the situation under control with clear visibility on the expected output in any scenario bringing in confidence especially when the data is not a guiding force.

Disclaimer: The views and investment tips expressed by investment experts on moneycontrol.com are his 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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