After completion of the second quarter of financial year 2021-2022, the quarterly results season has started. The developments thus reported would generally have enough raw material in them to create momentum in the stocks declaring results. We traders, being momentum chasers often times find opportunity to make money from this.
The size of moves could be big enough to give us opportunity to make money, but with results the direction is usually more uncertain than usual. So, the surprise that brings in the move could be positive or negative.
Trade betting on a positive surprise with a future or position in equity stock could run into a big trouble if the result comes up with a negative surprise.
Here we need a trade that has limited punishment despite being proven grossly wrong yet has open profit potential in case we are proven right.
Options fit the bill well. Such a case in favor of options for an event like result is widely known and accepted but due to certain inherent characteristic of options thru such event like results, many of us might not have been able to get the full potential of options.
Let us dig deeper into this characteristic and find a way to deal with it so that we can trade results much more efficiently with Options.
Now, as the result date comes closer, the uncertainty element rises. Options being the instrument pricing in expected volatility will become more expensive ahead of the event of result.
We need to accept the fact that we are buying something a little more expensive than usual. Typical Call/Put premium could be easily 30-50% higher than usual.
At the same time second aspect of this is that once the result is announced, the uncertainty is over. As a result, the Premium that rose led by event of result drops post the event of result.
To trade results efficiently now we have the change instrument to Options so that negative surprise does not punish us at the same time trade Options with a provision for such post-event fall in premium, so that the positive surprise yields us the most possible gain.
To get the best out of the positive surprise there are the following 2 strategic trades. We can choose either one of them that best suits us.
1. Convert the Buy Option trade into a Spread: A spread is basically Buy and Sell position in same kind of option (Call/Put) in the same Stock or Index. For us we will keep the expiry also the same. To create such spread if I Buy a Call/Put (depending upon my view), I will simultaneously Sell higher Call/ Lower Put.
For Example: For a stock trading at 100
Buy 100 Call
Sell 110 Call
110 is the point till which we are expecting the stock to move up to post the result. Profits in such a trade gets limited to the move up to 110 (as post that every rupee made in 100 Call will be evened out by rupee loss in 110 Call (sold)).
However, the good thing is that we are partially immune to the fall in premiums post-event. Also, this trade is inexpensive than the single Call, which makes more sense in times of inflated option premiums.
2. Back Ratios: Once again a trade which is in favor of volatility, here we would Sell the Call/Put that we were going to Buy and Buy 2 lots of relatively closer higher Call/ Lower Put
For Example: For a stock trading at 100
Sell 100 Call
Buy 2 Lots of 102.5 Call
Now this keeps the profit potential open in case if there is violent move expected which could take the stock to 120-125 and one does not want to limit the profits at 110. So, our profits would be open to whatever move one sees above 102.5 minus 2.5 (Loss on 100 Call Sold up to 102.5 as post 102.5 one of the two calls which will compensate the loss on 100 call post 102.5) and the premium outflow while creating the trade.
In both the cases in case the volatility does not come along, and the stock sees limited movement, these trades will still outperform the single options.
Good thing in both above trades is that in the event of us going wrong we will outperform just single bought option. So, from a clear Risk Vs Reward perspective, we are outperforming the Single option.
Disclaimer: The views and investment tips expressed by experts on Moneycontrol.com are their own and not those of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.
