Renowned financial analyst, Shubham Agarwal, discusses the nitty-gritty of credit spread Options strategy:
Equities have been in consolidation for a while now. The movement range of 2-3 percent in headline indices can frustrate any positional trader. While there are cases of such market conditions continuing for over a year, having such a phenomenon for a few months is not unusual.
Now that we know the problem, let us concentrate on possible solutions. Key characteristics of such range-bound markets are a few:
1. Moves do not last long
2. Market is not unidirectional
3. Trades against the trend take place very often
4. Momentum is fairly slow
Let us try and tackle each one of these characteristics one by one.
1. Moves do not last long:
In such cases, Options work wonders because here, one tends to lose less when the judgment is wrong and win more when it is right.
On top of this, if there is an expectation of a small movement, we can resort to spreads. This means we can buy one Option and Sell another, thereby reducing the impact of time and trend-related loss in Options.
2. Markets are not unidirectional:
In such cases, when there is no single decisive trend, Options trading is the best way to trade. The supporting argument is that commitment to trade is much lower with Options. More importantly, Options is the only method in which one can make bullish and bearish trades simultaneously.
3. Trades against the trend are made often:
Consolidation is a particular trading method, where one benefits from selling around the upper end of the range while the underlying market is in a rising trend. Similarly, bottom fishing is buying around the lower end of the range while the underlying sentiment is bearish.
Coming with considerably low risk, Options trading fits really well while trading against the trend in consolidation.
4. Momentum is fairly low:
Low momentum is not where one gets penalized for buying Options due to time value loss in Option Premium. On the contrary, one of the best trades, while the momentum is low, is Selling Options. The same time value creates economic value out of the reduced momentum.
Now that we know how remarkably Options fit into the consolidation state of the market, let us take each solution for each of the characteristics and build a trading strategy out of it.
Importantly,
Low Momentum = Sell Options
Short Moves = Option Spreads (One Buy Vs One Sell)
This gives us a simple limited loss strategy of Credit Spread. Here one Sells a slightly Higher Strike Call/ Lower Strike Put and Buys a further Higher Strike Call/ further lower strike Put.
When to Do this: Call Credit Spread (Bearish) at the top end of the range, Put Credit Spread (Bullish) around the bottom of the Range.
Strike Selection: Sell Strike close to the current market price and Buy strike closer to the stop loss (slightly outside the range).
Benefit: Strategy has premium inflow. If our view is correct, the Premium inflow will be ours.
Risk: Difference in Strikes (Bought and Sold) – Premium Received (Net of Buy and Sell Options)
This is one strategy that works wonders when there is a lack of momentum in the market. However, one of those days when the range breaks, the penalty for being wrong in that last trade is not very large. This makes Credit Spreads one of the most efficient strategies to trade consolidations.
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