Derivatives

How to set up a switch trade in derivatives

Venkatesh Bangaruswamy | Updated on April 11, 2021

This is a directional trade and can be compared to a bull call spread

Last week, we discussed the covered call strategy. This week, we look at switch trade, its characteristics and how to set up such a position.

Leveraged, directional bet

A switch trade can be set up by going long on the near-month futures contract on the underlying and simultaneously shorting an out-the-money call on the same underlying for the same maturity as the futures contract. A switch trade is, therefore, like a covered call but switching the underlying with futures.

There are two factors to consider before you set up such a position. First, a futures contract has an expiration date, unlike the underlying. This is important because if your directional bet on the underlying goes wrong, you could at least hold the stock if you set up a covered call. In the case of a switch trade, you have to close your futures position, perhaps, at a loss.

Of course, a roll-over is possible. This refers to shifting your long futures position from the near-month to the next month, preferably, a week before the expiry of the near-month contract. Note that a roll-over involves closing the near-month contract and simultaneously going long on the next month contract on the same underlying. But a roll-over can be costly because the next month contract can be trading at a higher price than the current month contract.

Second, the position is leveraged because you have to pay only the initial margin on the long position and the applicable mark-to-market margin. Suppose the near-month futures on an underlying trades at 2053 and the market lot is 250, the initial margin could be ₹1.15 lakh. On the other hand, if you buy 250 shares of the stock, you may have to pay ₹5.10 lakh. The biggest advantage with switch trade is the lower capital outlay compared to a covered call.

Your short call position should be on a strike that is above the resistance level. This is because the objective is to let the call option expire worthless and keep the premium collected. Note that you should mark the resistance level on the futures chart, not on the underlying.

The maximum profit on the position is the difference between the strike price on the call and the purchase price of the futures plus the call premium. In the above example, suppose you buy the near-month futures contract for 2040 and short the 2100 strike call option for 35 points. The maximum profit will be 95 points (2100 minus 2040 plus 35). The break-even for this position is 2005 (2040 less 35); the position will generate losses if futures trades below this price.

Optional reading

In the above example, suppose the chart pattern indicates that futures is likely to find a strong resistance near 2080. You can consider shorting more contracts of a call option with strike above the resistance level. If the underlying trades at or below the resistance level at option expiry, profits will be higher compared to that of a plain switch trade.

Suppose you short two contracts of 2100 strike for 35 points against one long futures contract for 2040, your maximum profit will be 130 points. The flip-side is that the position will expose you to large losses if futures trades above 2100. This is because the additional 2100 call will be a naked short position, exposing you to large losses.

Note that losses on one short 2100 call will be offset by the long position in futures for price movement above 2100. That is why a switch trade or covered call does not suffer losses even if the futures or the underlying trades above the short call strike.

Finally, even though this position has similar risks as a covered call, a switch trade is not an income strategy. This is a directional trade and can be easily compared to a bull call spread.

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

Published on April 10, 2021

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