As a trader, you may have engaged in stop-and-reverse (SAR) strategy, or you may be familiar with it. This week, we discuss how to use derivatives to set up an SAR strategy.

Trading efficiency

An SAR strategy is a trade where you take, say, a long position first. But if the underlying declines, you stop and reverse your position because you believe that the underlying is likely to decline, perhaps, having broken a recent support level. That is, you close your long position and take a short position instead. Suppose you first went long on 500 shares of a stock. When the stock declines, you sell 1,000 shares of the stock - 500 shares to close your long position and the other 500 shares to initiate a short position.

As with other strategies, short positions are best initiated through derivatives market because you are allowed to carry naked short positions. That is, you do not have to close your short positions till the expiry of the contract. An SAR strategy is typically based on rules framed from chart patterns. For instance, some traders use moving averages to determine the entry and exit points. Some others use indicators such as the Parabolic SAR.

An SAR strategy may require you to exit the trade intraday. Why? If you enter a trade based on a move above a price bar’s high, your stop-loss may be the bar’s low or the prior bar’s low. If the price hits that level, you will go short. But that presupposes that you are financially and emotionally comfortable taking the loss, albeit small. While an SAR strategy can be based on positional trades, the losses are likely to be larger because the price movement over two or more days is likely to be greater than intraday price movement.

The strategy is best setup using futures, not options. A call option or a put option is unlikely to give you significant gains from delta within a short time unless the underlying moves sharply in either direction. Also, if you short options on either side to capture gains through time decay, margin requirements are similar to that of futures. The benefit of initiating futures is that they move nearly one-to-one with the underlying, unlike options that are dragged down by time decay or theta.

Maximising gains
A call option or a put option is unlikely to give you significant gains from delta within a short time unless the underlying moves sharply in either direction
Optional reading

SAR strategy carries high risk of whipsaw. Picture yourself as a lumberjack cutting wood. You cut the wood when you move the saw away from you and towards you. Now, picture a strategy hurting you whether the price moves up or down. That is whipsaw. Suppose you initiate a long position, and futures price declines. You stop the position and reverse your trade. But if the futures price rises, you stop again and reverse your trade. Whipsaws happen when an underlying is not trending or trades in a range. It is important to create a rule to manage whipsaws before initiating SAR strategies.

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