The Hindu Business Line : Some profitable strategies for options traders

Ironically, trading in the derivatives market is skewed towards futures, though options offer higher returns due to non-linear payoffs. This article discusses a trading strategy that often converts a debit spread into a credit spread, and an alternative to downside averaging in the spot market.

B. Venkatesh

Investor interest in derivatives trading has risen over the years. Trading, however, continues to remain biased towards futures. This is because the futures segment is easier to understand than options. Profit opportunities are, however, better with options because of the non-linear payoffs.

This article discusses two options strategies. One is a trading strategy while the other is an alternative to downside averaging, meant for traders sitting on losses. It is important that traders have a view on the underlying before they set-up these strategies. Otherwise, the positions will lead to losses, as options are wasting assets.

Rolling up into bull spread

A bull call spread on Reliance Industries, for instance, can be set up for 35 points (times contract size of 75) with long May 2700 call and short May 2800 call. The trader’s view is that the stock is unlikely to move past Rs 2,800.

The problem with this strategy is that the May 2700 calls will lose more absolute value than the May 2800 calls if the stock sits still or moves down. This is because the profit due to time decay on the short-leg will not be enough to compensate for the loss in intrinsic and time value on the long leg.

To reduce the risk of loss, a trader can first set-up only the long-leg- buying May 2700 calls for 70 points. When the stock trades at Rs 2,750, the trader should sell the May 2800 call. The premium from the short-call will be higher, as the stock has since moved up.

Often, the premium received on the short-leg will be more than the premium paid on the long-leg. So, rolling into a bull-spread actually generates a net credit.

Suppose Reliance Industries moves to Rs 2,750 by May 7, the 2800 May call will trade at 80 points. Legging into spread will give a net credit of 10 points. If the stock sits at Rs 2,800, the position will generate a maximum profit of 110 points- the difference between the strikes plus the net credit.

Rolling down into bull spread

What if the stock declines by Rs 50 a week after the long-leg is set up? Then, the May 2700 call will trade at 40 points. Legging into a spread by selling a higher strike call will not help as the option will fetch a lower premium.

The trader should instead sell two May 2700 calls for total credit of 80 points. This will create only one short position, as the other will close-out the previous long position.

Next, the trader should buy the May 2600 call for 75 points. The position set-up will be a bull spread with 2600-2700 strikes.

Inside ratio spread

Investors often hold on to their loss-making positions. The following strategy is meant to reduce losses on such positions. Suppose a trader buys 75 shares of Reliance Industries at Rs 2,625. If the stock declines to, say, Rs 2,500, the trader will be tempted to buy more shares to average her cost! Averaging, however, requires more capital.

The trader can instead use options to stay profitably in the trade. Assume the view is that the stock could move back to Rs 2,575. The trader can set-up a call ratio spread. This involves buying one call at lower strike and selling two calls at higher strikes.

The trader can set-up this position with one long May 2550 call and two short May 2600 calls for net credit of 30 points, assuming that the stock declines to Rs 2,500 by April 30.

The portfolio now consists of one ratio spread and 75 shares. The total exposure is equivalent to two long positions (one long call and 75 shares) and two short positions (two short calls).

This strategy can be implemented only when the trader holds shares equal to or in multiples of option contract size.

If the stock continues to decline, the net credit of 30 points can act as margin of safety. If the stock moves to Rs 2,575 or Rs 2,600 at expiry, the 2550 call will expand to 50 points.

At a spot price of Rs 2,600, the ratio spread + long stock position will generate maximum profits of 25 points! So, the trader can essentially convert losses into profits.

Conclusion

The trader should equip herself with the following information before setting up the above two strategies. First, she has to have a view on the underlying.

Second, she should know the major support and resistance levels to gauge the likely turns. And third, she needs to choose the right option strikes. These strategies are just two of the many that an options trader can profitably set up. We hope to cover more such strategies in this column in the future.

(The author is an investment strategist. He can be reached at enhancek@gmail.com)

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