Indices fall into a consolidation rut every few months. And investors end up getting used to trading small. Small in terms of horizons, targets and stop losses. However, it turns a little tricky when the indices and majority of heavyweight stocks come around the edge of the range (especially the lower edge of the range).
In times such as now, when the Nifty is trading around the lower end of the trading range, investors are presented with two choices. One is to keep trading the ongoing trend and continue with the bearish trades. The other is to appreciate the fact that the market is close to the lower end of the range, and start bargain-hunting.
There are specific strategies to trade in such uncertain times. These strategies will majorly focus on safeguarding the downside in case of being wrong. Each of these following three strategies is aimed at catering to specific views. Let us look at them one by one.
1. Back Ratio Spreads
This strategy involves selling one Option with the strike closer to the current market price (CMP) and buying not one but two Options of higher Strike Call (against Call Sold), or Lower Strike Puts (against Puts Sold).
Sometimes the indices breach the range, especially on the lower side. This creates expectation of a big breakdown. This is the view that the Back Ratio caters to. The conviction on the big move of either breakdown or bounce back is affirmed and that too within a very short span of time.
When the Back Ratio of the breakdown takes place, investors would end up making good money following a big move as a result of the two Options bought against one sold. But, if volatility is on the other side and the big opposite move sets in, all Options would start reducing towards zero. This would be fine because the net premium outflow, if all goes to zero, is negligible.
The only caution is the big view of volatility. If volatility does not come around in the next couple of days, then get out of the trade. Again the cost of carrying the trade for two to three sessions would not be much. Also, make sure that there is at least a week left for the expiry.
2. OTM Spreads
This is for the opposite trade. A good number of times in a range-bound market, once a range is established, investors end up taking bullish trades at the lower end of the range, and vice-versa. However, in reality the investor is taking a trade against the trend. Most of the trades go well, except for that one last trade, where the range gets broken and the cost being wrong washes off all the small profits made from the previous trades.
Hence, in such cases, from the beginning turn to OTM Spreads. For a bullish trade, one does a Call spread, and for a bearish trade, one does a Put spread. OTM Spreads are created by Buying slightly higher strike Call/ Lower Strike Put and Selling further higher strike Call / lower strike Put.
The benefit of this strategy is that the initial outflow (net premium paid) is fairly low. And the maximum profit, which is the difference between the strike minus the premium paid, is generally two to three times the maximum loss of net premium paid. We are saved in case of few days of consolidation before the reverse move, since we have one option bought against one sold. Most importantly, in case the call goes horribly wrong with no chance to exit at the desired stop loss level, the maximum loss is limited.
3. Time-bound Long Options
This is a very short-term speculative trade. Such a trade is undertaken in the market where things look overdone. This situation, which is typically a bullish trade in a highly oversold market and a bearish trade in an overbought market, calls for a contra trade.
Here, instead of buying a Future, go long (buy) on a Call / Put for bullish / bearish trade. If everything works out and the reversal takes place, the investor will make a quick buck. If the market continues with the direction, the cost of taking a brave trade is small. What needs to be kept in perspective is that the trade be kept time-bound. If nothing happens and the underlying goes into lull the next day, exit the Option bought. Keep a tight two-session stop loss.
These are a few ways to trade the edge of the range.
Disclaimer: The views and investment tips expressed by experts on Moneycontrol are their own and not those of the website or its management. Moneycontrol advises users to check with certified experts before taking any investment decisions.
