How to use call ratios for upward reversals
They say that Options trading requires skill, as the great convenience of designing non-linear pay-offs comes with a caveat — keeping the other characteristics on their best behaviour. A small mistake in choosing a strategy can ruin the final pay-off, instead of the view going right.
But on the other hand, if traded well, these characteristics can yield us better pay-offs with same risks or similar pay-offs at marginal risks. One such set-up and reactive strategy which we will discuss are Upward Reversal and Call Ratios.
Typically, after a series of down moves, there are always those well-rounded levels around where the reversal initiates. Now considering the preceding trend, taking an upward looking trade would be like catching a falling knife. Hence one would be on the lookout for utmost prudence.
This is where Call Ratios come in handy. The risk profile of Call Ratios on the downside is extremely limited. Yes, we do have a strategy in hand now which has unlimited loss profile, but the first concern of “Trying to catch a falling knife” is taken care of.
Call Ratios are executed by buying a Call Option, and selling two lots (most of the times) of higher strike Call options. The cost reduces significantly of the bought Call, funded by sold Calls’ premium.
The pay-off during the expiry is rising and starts to top out on its way of approaching the Sold strikes, and from then on, it gets into an unlimited risk profile mode.
This topping out of profit is dependent on how far the sold strikes are from the bought ones, and how long does it takes for the stock to move. Farther the strikes, and longer the time taken for rise will yield improve the results.
Now let us examine the situation with references to those characteristics of options that we talked about in the beginning and see if their behaviour is helping us. To dig deeper into it let us look at two other factors that are determinants of Option Premium.
Painful Characteristic: The first one that we will take up is the compounding factor, which makes the Call premiums rise at an increasing speed with every increment in the price of the underlying. This is the factor that is responsible for the topping out of our profit despite of the rising regime adopted by the underlying.
Typically, the solution that I have always resorted to is get the distance in the bought and sold strikes as much as one can. On an average, for the likes of HDFC Bank and HUL, it is 5-7 percent, and for ICICI Bank & Axis Bank, at least 10 percent. (Highly Volatile Stocks like YES Bank are disqualifiers in my list).
Mostly, in such situations though, indices are the first targets to execute these ratios. Despite of these guide lines though, what I practice is to get an option calculator (Easily available nowadays), and check the pay-off with passage of just one day. If the expected target is making money that justifies the premium paid, then execute.
Gainful Characteristic: One sweetener is another factor of risk premium, which raises the premium with a rise in the risk level of the market, regardless of the price. Now since the upward reversal is in play, the riskiness will start going down, which pushes the premiums down. This will add a surprise element of profit into the strategy if the view goes right. This is the factor that has made Call Ratios work for me in reversals.
Finally, as a common prudence, always keep the strategy protected with a stop loss not more than 1.5X of the premium we have paid. Once that is seen in the book, simply get out of the trade. Remember, we have ventured into an unlimited risk profile trade at all times and execute caution.
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