Mastering Derivatives: Salvaging a failed breakout

Last week, we discussed why long futures position is optimal to take advantage of a cup and handle pattern. Despite the strategy being a high probability setup, there are chances of the pattern failing to continue its uptrend. What if the pattern fails after you initiate a long futures position? This week, we discuss how to manage your futures position when an underlying fails to continue its uptrend after a breakout from the cup’s rim.

Losses or gains?

Suppose you initiated a long futures position after the breakout, but the underlying declines thereafter. You must re-evaluate your outlook. If your previously-held bullish view on the underlying is no longer valid, you must close your long futures position and cut your losses. This is because futures moves nearly one-to-one with the underlying. Multiply every one-point move by the permitted lot size and the losses can be significant.  

But what if you expect the underlying to move sideways or move up marginally and slowly? Suppose you expect the underlying to move up 50 points by the expiry of the contract. Note that potential gains in futures is not affected much if the 50-point move happens the day after you setup the position or at expiry. This is quite unlike options, which has a high time decay. You should take advantage of how options and futures behave differently with passage of time. How?

Given your view that the underlying is likely to move sideways or move up slowly, you should short an out-of-the-money (OTM) call against your existing long futures position. The strike you choose depends on your risk attitude and your view of the underlying. A more conservative approach would be to identify an immediate resistance level and short one strike above that level. A more aggressive approach would be to short the immediate OTM call. 

The objective of adding a short call to your existing long futures is to profit from time decay as the underlying moves slowly or sideways till expiry. Importantly, the small gains from time decay may reduce, if not offset, the losses (or loss of gains) on the existing long futures position. This strategy could be optimal if the time to expiry is neither too long nor too short. Too long a time for expiry allows for large time decay capture but leaves room for the underlying to move down significantly, causing harm to the combined position. Too short a time would mean the short call may not gain much from time decay because of lower time value. One week to 10 days to expiry could be optimal.

Take note

The objective of adding a short call to your existing long futures is to profit from time decay as the underlying moves slowly or sideways till expiry

Optional reading

You should cover your short call position before you sell your long futures position to avail the benefits of cross margin. Note that the argument about attaching a short call also works if you have an existing long position on the underlying (in multiples of the permitted lot size) instead of long futures position.

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