Derivatives

Why you should go for adequate stop-loss in options

Akhil Nallamuthu | Updated on March 06, 2021

Suppose, Nifty is trading at 14,000 I would sell 13,900 Put and sell 14,100 Call option keeping a stop-loss of around 10 points on each side. When volatility goes up, there may be losses on both sides. How can we guard against such losses?

- H. Rathnakara Shetty

Placing a stop-loss is the primary tool to limit loss but it is important to take adequate cushion.

So, you may have to rethink about selecting the strike price of the option that you wish to trade. If you trade in Nifty 50 options, use average true range (ATR) indicator, which tells us how much the index can move during a given time frame. For instance, say Nifty 50 index closes today at 15,000 and the daily ATR is 250. This means, the index is equally likely to touch 15,250 or 14,750 the next day. So, it it is better to short 15,250-strike call and 14,750-strike put options as the probability of index going above 15,250 or below 14,750 is low.

Stop-loss can be decided based on ATR. Take the 15,250-strike call. Since it is an OTM option, the delta will be less than 0.5. Say the delta is now 0.25, meaning, if the Nifty moves by 100 points, the option price is expected to move by 25 points.

Now, putting it all together. Nifty at 15,000 is likely to move to 15,250 i.e., 250 points. Hence, the 15,250-strike call option with 0.25 delta can move 62.5 points (250 multiplied by 0.25) and so the optimum stop-loss for intraday selling of this call option should be 62.5 points.

Similarly, it can be worked out for short put option.

Published on March 06, 2021

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