When markets are under pressure, we are both scared and excited. Scared because, well wealth destruction is not liked by any. Excited because the falling prices are now presenting us with prices of the stocks and indices that we always wanted to enter but missed.
Such situations are traded with one of the most conservative of strategies. Options are used in this situation because if we do go horribly wrong also, we will not be out of pocket with a small amount of premium at stake.
It would all be ok in normal situations but there is one crucial way in which Options behave in times of rebounding from the lows. On its way up from the lows the risk in the market decreases. This development pushes the premiums down of the options (irrespective of the prices
Example:
Stock is at 100 today after rising from 90, if 100 Call is at 2
The same 100 Call would be trading at 3 or more if the stock is at 100 after falling from 110.
So, imagine you bought the Call option to trade the rebound and Prices rose, and the Premium went up but it was so under pressure due to a drop in the risk in the market so much that you ended up making very less for your bet.
On top of this, there is a risk of time value degradation. For some reasons, if the stock or index goes for a breather of a few days and then rises, such passage of time will push the premiums down on top of that.
Hence, one handy alternative is ATM Bull Put Spread. Let us break down the name of the strategy and see what it means and how it would be helpful.
ATM: The strike we select will be close to the current market price. Since we want maximum action best place to be trading in options is in ATM strike.
Bull Put: Bull Put gives the Option type and the transaction type. Bullish position in Put option can be created by Selling a Put Option.
Spread: Spread in this case predominantly means having a simultaneous Buy and Sell positions in 2 Options of the same stock or index, same type and same expiry but of different strikes. In our case we will be buying a Lower Strike Put to make sure that we are not exposed to unlimited loss profile by just Selling the Put.
Carrying forward the same stock example with Rs 100 stock that has fallen from Rs 110
Sell 100 Put
& Buy 95 Put (lower strike).
This trade will have the Maximum gain of Net Premium Received. Maximum Loss will be Difference between Strikes – Maximum Gain
Generally, Bull Put Spread will give us a similar or even bigger Maximum Loss figure than a Maximum Gain.
Exit Strategy: The exit strategy in this trade would be the price point when we feel that the nearby lows that we just hit have broken. Do not wait for the whole expiry even though this is a limited loss strategy.
In our example, if the stock came down from 110 to 99 and we took a rebounding trade at 100, I would be out of the trade if the stock breaks 99 and would not wait for the whole expiry even though the strategy is a limited loss strategy.
Benefits: Now we have taken care of all the pain points.
> The drop in the Premiums due to Drop in risk will work in our favour due to more expensive Put being sold
> Rise in Stock or Index will help us get money because Put being sold
> In case there is a delay in Price action and consolidation kicks in, we will benefit then as well because we have more expensive option sold
The strategy does come with a pitfall, which is the limited profit profile. The way I use ATM Bull Put Spreads is, as soon as the rebound is confirmed, I will book profits in conservative ATM Bull Put Spread and create a more aggressive bullish strategy.
Thus, in times of fright of fall a pro-rebound ATM Bull Put Spread is a handy strategy till we conclude that the rebound has converted into a Bullish trend.
Disclaimer: The views and investment tips expressed by investment experts on Moneycontrol.com are their own and not those of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.
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