To state that market timing is difficult is axiomatic. But the point is that timing a position’s exit is more difficult than timing its entry. Your emotions play an important role in the process. When you are entering a position, the excitement of potential gains reduces the anxiety of timing the entry into a long or a short position. The issue with exit is that it determines your gains. Exit too soon and you are likely to regret the potential gains that you give up if the price moves up further in the direction of your trade. Exit too late and you are likely to regret the potential losses or lower gains because of your decision. This week, we explore whether combining a position in the underlying with its derivatives can help moderate the regret associated with market timing.
SIP and market timing
Shorting futures requires less capital than shorting in the spot market and importantly, is more efficient to setup. This is because you are allowed to carry your short futures position till expiry (naked short), whereas you must borrow shares to settle your short position in the spot market. Now, what if you take a long position in Nifty ETFs through systematic investment plans (SIPs) and short the near-month Nifty futures whenever you believe that the index shows short-term weakness?
The objective of this position is two-fold. One, you are continually long on the market through the SIPs on the ETF. This enables you to capture gains from an uptrend in the Nifty Index. And two, you short the Nifty futures to capture short-term reversals while all along holding your long positions in the ETFs. If you time the short position correctly, you can capture significant gains. If the index moves against you, you may have to close your short futures at a loss, but you can draw comfort from the fact that you are still long on Nifty ETFs.
You may argue that this strategy is a hedge against the ETF. Technically, it is not. For one, your short position is not based on a hedge ratio that considers the correlation between the ETF and Nifty futures. For another, hedge is not meaningful for the short term unless you want to protect the wealth accumulated in the ETF to achieve a goal whose time horizon is ending soon. Also, this strategy is part of your trading portfolio, not your goal-based portfolio.
Optional reading
Previously, we discussed how to apply candlestick patterns to catch reversals. Last week, we discussed about fading prices using market profile charts. You can use these tools to initiate a short position in futures when you deem fit. The strategy of combining long underlying with short futures is best suited for the Nifty Index. Setting up SIPs on individual stocks with short positions on their futures contracts may be risky because of the greater volatility that individual stocks carry compared to the index.
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