You must have a directional view on the underlying if you want to set up a long or a short position in futures. This is because futures move in lock-step with the underlying. What about options? This week, we discuss why you can set up option strategies even if you do not have a directional view on the underlying.

Volatility bets

Volatility is a dominant factor driving option prices. This is because you have the choice of buying or selling the underlying using options and this choice becomes more valuable as the volatility of the underlying increases. It also means you can trade options without having a directional view on the underlying. Here is how.

Consider two stocks- A and B. The chart pattern for stock A gives you confidence that the stock is trending up. You could, therefore, set up a long futures position on the stock.

Suppose the chart pattern for stock B suggests that the stock can either go up or come down, but you are not confident which way the stock is likely to move.

This would typically happen if the stock has been trading in a narrow range for a long time. Draw a resistance line and a support line joining the top and bottom of this trading range. Typically, stocks trading in a narrow range eventually break out of the resistance level or break down below the support line, depending on which group emerges the winner- the bulls or the bears. You should, therefore, consider buying a call and a put on stock B. If the stock breaks out, the call will be profitable. And if the stock breaks down, the put will be profitable.

Such strategies are volatility trades because you are betting on sharp movement in the underlying. For this reason, you should avoid buying both calls and puts when the chart is noisy and does not indicate any clear trend. If you do not see a pattern on the charts, you should not set up any position. Volatility trades lose the most when the underlying does not move enough.

One way to identify stocks poised for a break out or break down is to set a filter for stocks with narrow Bollinger Bands (BB). These are volatility bands with a default-setting of a 20-period simple moving average and two standard deviations on either side of this moving average. In the coming weeks, we will discuss how to set up various volatility strategies including straddle, strangle, strip and strap.

Optional reading

Buying calls and puts when you expect the underlying to break out or break down can be profitable because of the asymmetric pay-off on options. When you buy both calls and puts and the stock breaks out, the puts lose value.

But the maximum you can lose is the premium paid on puts, whereas the sharp up move in the stock will make your calls profitable. Consider an at-the-money call option. When the underlying breaks out, this option will become in-the-money.

If the stock moves up 150 points, the intrinsic value of the call will also increase by 150 points. If the sharp movement in the underlying price happens before option expiration, you can capture some time value as well. The point is that the profit on the call will be significant and will cover for the costs of both the call and the put. The same argument holds if the stock breaks down, as the put will generate profits.

Volatility strategies also work well during macro-level events such as the Union Budget and the national election because of the uncertainty of the event’s outcome. Note that buying calls and puts is risky. Unless the stock moves sharply either up or down to recover the total cost of both the calls and puts including the brokerage, you will not make profits on your position.

The writer author offers training programme for individuals to manage their personal investments.

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