Missed the fall? A lot of traders among us must have asked this question to each other at the end of this week.
Many times markets prove the consensus wrong. All it takes is a day of a huge fall and which is what happened in the week that went by. We do need the courage to start initiating Sell trades after a big drop.
The solution lies in resorting to options for trading any further down move. The biggest fear is that what if we sell and that turns out to be the bottom. First of all, with options, there are no such commitment issues.
In simple words, if I want to initiate a sell trade, I can simply buy a Put option. There is a key characteristic of limited loss in buying options. I know that even if where I have initiated the trade is the bottom and tomorrow there is a big bounce, I will not be trapped in a big loss. The most I will lose is the premium paid.
The first problem of being too late is taken care of. It is the problem of the possibility of loss due to the late entry into a fall that turns around very fast.
Now, the second problem. We know that options limit loss but it is still a loss. Also, if we carry on with the same option for more than one or two days, we will definitely see a reduction in premium due to the passage of time—Time Value Decay.
At the same time, there is also a possibility of a huge return if there is a back-to-back fall. So, the choice of the Put option buy is right.
Here comes the importance of a staggered option strategy, a strategy executed in steps. The first step is already done with the buying of Put.
Now, only one of the following three possibilities can happen in the underlying stock or index whose Put option we have bought:
1 Reverses
2. Falls Further
3. Consolidates
In the first case, there are no further steps. As a disciplined options trader, we would trigger our stop-loss and exit the trade. We now know that it was not the right time and we await another opportunity to buy another Put.
If it falls further, we know the trend has reversed and we would like to be in the trade.
Considering that we chose the Strike price closer to the current market price for buying the Put option when we initiated, we can now sell the Put option of strike closer to the current market price after the fall.
Example:
With Stock X @ 100,
I Buy 100 Put Option @ 3
Stock X falls to 95
I Sell 95 Put Option @ 2.5 (instead of booking profit in 100 Put).
What this will do is create a staggered option strategy, with the second step created after some time. The profitability of the trade will now be much better.
Our maximum Profit = 100 – 95 – 100 Put premium paid + 95 Put premium received
= 100 – 95 – 3 – 2.5 = 4.5
Our maximum Loss = 100 – 95 – maximum profit
= 5 – 4.5 = 0.5
Now we can hold on to the trade without having to worry about a) a fall in premium due to the passage of time b) a fall in premium due to a bit of a relief rally after the back-to-back fall.
In the third case of a consolidation, we again do the same and sell 95 Put. Every calculation of maximum profit and loss remains the same as above.
One may wonder why do this late or staggered. For two reasons:
1 After a consolidation (digesting the fall), as seen in the past, the chances of a further fall increase
2 By delaying the execution, we open up an opportunity that was presented to us in the second possibility of a back-to-back fall.
Thus despite being late in trading the fall, we can profit from it with limited loss potential using the staggered option strategy.
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.
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