Derivatives

How you can book profit, but still enjoy upside

Venkatesh Bangaruswamy | Updated on May 16, 2021

The approach uses long call to moderate the disposition effect

In the previous three weeks, we discussed how to manage long call, long put and long spread positions. This week, we discuss how to use long call to moderate the disposition effect, a behavioural attitude that drives individuals to take profits quickly.

Upside potential

Suppose you bought 100 shares of Tata Steel at ₹960 per share. With the stock trading at ₹1220, you are nervous about giving up the unrealized gains.

As humans, we are typically risk averse when we have unrealised gains, but risk seeking when we carry unrealized losses. This behaviour drives us to take our profits quickly because we fear the stock may decline, wiping out our unrealised gains. We keep our loss-making positions for too long hoping that the stock may turn and recover these losses. This behaviour is called disposition effect and can be attributed to our inherent nature to avoid losses.

The disposition effect leads to another dilemma. You have 260 points (1220 less 960) of unrealized gains on your stock. If you do not take profits and the stock declines, you will regret. And yet, you will suffer just as much regret if you sell your holdings, and the stock continues to move up thereafter! Can you take profits and yet participate in the upside?

Here is what you can do: Take profits on the stock. Then use some of the profits to buy an at-the-money (ATM) call option on the stock. This strategy has several benefits. First, you have locked in to your profits on the stock. That reduces your anxiety levels of losing out on unrealised gains. Second, you can still participate in the upside movement through the long call. Three, the maximum loss is limited to the option premium, which is a proportion of your realised profits on the stock. The above strategy works well if the cost of the long option is less than 50 per cent of your realised profits.

Note that this strategy can be set up on the Nifty and the Bank Nifty indices as well; your initial long position has to be through ETFs on the Nifty index or the Bank Nifty index. Your strategy will be better aligned if the underlying shares or units you hold are in the market lot of the options contract. That is, in the case of the Nifty index, you have 75 units of the ETFs or in multiples thereof. You can either hold the long call till expiry or close the position any time before, depending on your view on the underlying. The advantage of closing before expiry is that you can also capture the time value of the option.

Optional reading

An ATM call is preferable because it has the highest gamma and vega; ATM call is the one that is closest to the underlying price.

You can also reduce the cost of your long call. Suppose you have a view that the underlying will continue to move up but may find resistance at a certain level. You can set up a bull call spread- buy the ATM call and short one strike above the resistance level. This way, you can participate in the upside at a lower cost. The flipside is that your maximum profit is limited to the difference between the strikes less the net debit (cost of setting the call spread).

Setting up a long call or a bull call spread substitutes for active management of your long position on the underlying. Suppose you bought 400 shares of Tata Steel at ₹960. You may choose to sell 200 shares at ₹1220 and keep the remaining with a trailing stop loss. But you have to continually monitor the stock and trail the stop loss. Managing the position is easier if you take profits on the underlying and buy a call or a call spread instead.

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

Published on May 16, 2021

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