Last week, we discussed why futures should be preferred over options for momentum trades. Continuing the discussion, this week we look at why options should be preferred for betting on trend reversals.

Asymmetric benefit

Options have asymmetric payoff. That is, the maximum you can lose on a long option position is the premium you pay to buy the option. But your gains could be greater. Suppose you buy the next week 18,000 call on the Nifty Index for 227 points, your maximum loss will be 227 points. If the index moves to, say, 18,500 at the option expiry, the call will be worth 500 points and your profit will be 273 points. Your potential gains can be more than the losses.

The asymmetric benefit of options contrasts with the symmetrical payoff on futures. That is, if the underlying moves up or down 100 points, futures will gain or lose 100 points. It is for this reason that you should consider options for betting on trend reversals. For such trades can be risky if the underlying continues to move in the same direction instead of reversing.

Suppose there are signs of bull exhaustion, and you expect a trend reversal. You could buy a put option rather than short the near-month futures on the underlying. Likewise, you could buy a call option on a stock that tests a support level and is ready to move up.

Buying a call option in anticipation of a price turn is beneficial because there will be more demand for puts than calls when the underlying falls. Lower demand for an option often translates into lower time value, which means lower time decay as the option approaches expiry.

Your preferred choice should be the immediate out-of-the-money (OTM) strike for two reasons. One, the absolute cost will be lower than the at-the-money (ATM) strike. And two, if your bet turns right, you can let the underlying move up for a while before your take profits on your option. Note that early exercise is not possible as these are European options. This means you must sell the option to take profits. But deep in-the-money (ITM) strikes are typically less liquid than ATM and immediate OTM strikes. By choosing an OTM strike, you can let the underlying move till the strike become immediate ITM before you sell and take decent profits.

Optional reading

You can also set up a spread trade to reduce loss due to time decay. Suppose you want to set up a call spread for a possible reversal after a downtrend. You can buy an immediate OTM call and short an OTM call one strike above your price target. The gains from time decay on your short call will reduce the loss from time decay on your long call. Likewise, you can set up a put spread for a reversal after an uptrend.

Should you consider shorting a put option to bet on a reversal from a downtrend? You can benefit from time decay, which can be significant when the implied volatility is high. But the risk is greater, as the put will quickly become ITM if the downtrend continues. So, shorting calls or puts to capture trend reversals may not be optimal.

A final note: You should establish rules to catch trend reversals. You can, for instance, combine candlesticks or range bars with Bollinger Bands. A green candle that punctures the lower Bollinger Band but closes above it (preferably at the day’s high) could be a first sign of bulls re-entering a stock if this setup happens after a continual price decline (series of red candles). Suppose this happens on Tuesday, your rule could be to buy calls on Wednesday when the underlying breaks above Tuesday’s high. The reverse is true for bears re-entering a stock after a continual uptrend. You should back-test your rules before implementing them.

The author offers training programmes for individuals to manage their personal investments

 

(This is a free article from the BusinessLine premium Portfolio segment. For more such content, please subscribe to The Hindu BusinessLine online. )

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