There is no doubt that the favorite market for most traders be it retail or institution is the options market. The risk profile suits the institutional investors and the returns potential is what attracts the retail trader. Most retail traders however, end up bearing a loss most of the time. One of the reasons is that these traders do not have a plan and the second is they have the same plan for all occasions. The following are strategies according to various market scenarios.
Market Scenario and corresponding strategy
Sideways or moderately bullish or bearish:
Apart from a few high beta or highly volatile stocks most stocks generally move slowly. The strategy to use in case one has stocks in their portfolio or intends to take a new bet is the ‘covered call’ or ‘covered put’. This strategy is used to earn money when the trader expects slight change in the price of the underlying stock.
If one wants to protect their downside risk too, then he would create a ‘Vertical spread’. In case a trader is slightly bullish he can set up a vertical call spread, which is nothing but buying an ‘in-the-money’ call and selling an ‘out-of-the-money’ call option.
When Market Or A Stock Is Lacklustre
There is barely any movement which causes the option price to fall though the underlying stock is not doing much.
Assume Nifty is moving in a range of 8400 and 8600 just ahead of budget announcement. A short straddle can be created by selling both the call and put option of the same strike price. In the present case one can create a short straddle by selling the 8500 call as well as put option. Maximum profit is possible if Nifty closes at 8500. The trader needs to be careful in closing the position ahead of the event as stock markets are likely to blast away in one direction which will expose him to huge loses. A short strangle can also be created by selling call and put options of different strike prices. In the present case it would mean selling an 8400 put and an 8600 call.
How to trade a major event: Just ahead of a big event, like an election or a credit policy or a result markets and stocks tend to move in a small range before blasting away in one direction. Since the outcome is unknown the best strategy during such times is to create a straddle or a strangle.
Straddle is created by buying a call and put of the same strike. This strategy is most commonly followed by traders during Infosys results. However, as the date of the event nears, the premium of call and put both increases substantially thus reducing the chance of a profit.
Strangle is created by buying a call and put of various strikes. In the case of Nifty a trader can buy a 8400 put and 8600 call in anticipation of market moving away on one direction.
How to protect your profits: In case a stock or the index that a trader has bought moves up sharply and the trader is keen on protecting his profit, he creates a ‘Protective collar’ strategy. The trader purchases an out of the money put option and at the same time writes an out of the money call option.
The beauty of option is it allows one to be very creative, but a trader needs to keep in mind his cost of setting up a strategy. The most important reason professional traders prefer options is because it informs them of their risk and potential reward in various market scenario.