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Last week, we discussed why you should use intra-day price stops when you trade options. The fact is that it is emotionally challenging to take price stops, especially for positions in the spot market. For one, losses cause more pain than gains of the same magnitude can give us happiness. For another, positions in the spot market do not have a finite life. So, unrealised losses can be held for an indefinite period. That said, traders sometimes use options to protect the downside risk on their underlying position instead of using price stops. This week, we discuss how effective long puts and short futures are as alternatives to price stops on your long underlying position.
Time decay and delta
Buying a put option ought to help protect the downside risk on an underlying. Unfortunately, you must deal with time decay — the loss in option price with passage of time. Let’s say you buy the 18300 next week put on the Nifty Index for 79 points as a protection for a long position on a Nifty exchange-traded fund (ETF). Further consider the Nifty Index declines from 18398 to 18300 two days after. The 18300 put is likely to gain 27 points, but the loss on your ETF will be close to 98 points; instead, if the index declines to 18200 during the same period, the put is likely to gain 81 points, but your ETF would have lost close to 200 points. Note that the gain from the put will only reduce, the longer the index takes to decline.
The above discussion suggests that put options do not really provide protection on your long position. Long puts, perhaps, delay the perceived need to cut losses on the underlying. What if you attempt to salvage unrealised losses on your long position by shorting futures? The advantage with futures is that it moves one to one with the underlying. So, if the Nifty Index declines 79 points causing a similar loss on your long ETF position, your short Nifty futures position can gain nearly 79 points to offset the loss. Of course, there are several factors you should consider before setting up the position. One, you must have an identifiable price stop on the Nifty futures below which shorting futures will be meaningful. And two, you must have an identifiable support level at which you must close the short futures position. This strategy will be optimal if the Nifty Index pulls back from the support level towards the entry price for your long position. The objective is to use short futures to offset the unrealised loss on your long ETF position.
Optional reading
The futures-salvage strategy is optimal only if conditions discussed above are satisfied. It is efficient to take price stops on the underlying instead. One way to develop a trading discipline is to have a stop-loss buddy. That is, have your best friend take your price stops and you take your friend’s stops.
The author offers training programmes for individuals to manage their personal investments
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