InvestorQ : I understand that options are risky but can I use options at a time when the markets are literally going nowhere?
Debbie Mascarenhas made post

I understand that options are risky but can I use options at a time when the markets are literally going nowhere?

Answer
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Crowny Pinto answered.
1 year ago


The interesting thing about options is that it can be used to take a limited-risk view on all kinds of markets. It could be bullish markets, bearish markets, moderately bullish markets, moderately bearish markets, volatile markets or lacklustre markets. Let us look at the use of options in lacklustre markets in greater detail. It sounds ironic that options trading, which is normally equated with high risk trading, is actually a great product to play lacklustre markets. A word of caution! Not all lacklustre options strategies are risk-free. In fact, in some cases they are highly risky strategies unless the risk is smartly managed. Let us look at 4 such approaches to play markets that are lacklustre and that can be a low risk strategy if managed and executed properly.

Make a point of using long / short strategies effectively…

The beauty of the options market is that you can play the market both ways. Normally, even when the markets are lacklustre, it is the index and the frontline stocks that are lacklustre. The sub-plots and the sub-themes in the market are still at play. During the 2012 period when the markets were largely lacklustre, you had sectors like consumer goods and pharma that were outperforming while capital goods and banks underperformed. In 2016, the situation was reversed when pharma and IT were underperforming while metals and downstream oil were outperforming. The idea behind a long/short strategy is to play such specific themes; one on the long side and one on the short side. Of course, these are not risk free but by being as close to the momentum as possible you are not just betting on individual performance but on relative outperformance. You can both buy and sell futures or you can buy call and put options to execute this long/short strategy!

You must realize the merits of using short straddles to benefit from lacklustre markets…

A straddle is a hybrid strategy wherein you simultaneously sell calls and puts on the same stock or index in the same expiry at the same strike price. Let us say you expect RIL to be in the range of Rs.890 to Rs.910 for the month of November 2017. Let us also assume that the 900 RIL call option is available at Rs.20 and the 900 put options is available at Rs.15. If you sell 1lot of 900 call options and 1 lot of 900 put options, then your total premium income will be Rs.35 (20+15). However, the assumption here is that the price of RIL must be in the range of Rs.865 to Rs.935, which is broadly in line with our view on Reliance. As long as the stock price is in the range of Rs.865 to 935, you are safe. If the stock crosses either of these levels, then you have a problem on hand as losses can mount and you will have to close your position by triggering a stop loss. You will prefer that the stock price closes the month near the Rs.900 mark as it will ensure that the entire premium earning of Rs.35 comes to you. This is a popular strategy during lacklustre times.

You can actually improve upon your straddle with a broader based strangle

A Strangle is a slightly improved version of a straddle. The risk in a straddle is that the margin for error is too low since both the call and put have the same strike. This increases risk in case markets show signs of volatility. An improvement to the straddle can be the Strangle. What a Strangle does is to use different strikes for calls and puts to expand your safety zone and reduce your risk. Of course, in the process you give up some returns but that is a risk worth taking. Let us go back to the above example. Now instead of selling a call and put of 900 strike, what you do in a strangle is to sell an RIL 880 put at Rs.16 and also sell a 920 call option at Rs.12. The total premium earned in this strangle is only Rs.28 as compared to Rs.35 in the straddle. But, your protection zone is now between Rs.852 and Rs.948. In the case of the straddle, you will have to hope for the stock to close around Rs.900 to earn full premium. In the case of strangle, you will earn the full premium if the stock closes in the range of Rs.880 to Rs.920. That is the reason, strangles are a lot more popular in the real world.

You can also use spreads to make the best of these lacklustre markets

Spreads are a kind of a long/short that we have previously seen but they are a little more complicated and sophisticated. Let us look at two such examples. An option spread can be used in case of moderately bullish or moderately bearish situations. An option spread combines buying a lower strike call and selling a higher strike call. Alternatively, you can also buy a higher strike put and sell a lower strike put if you are moderately bearish. The premium received on one option reduces the cost of the other option and the risk is limited. One can also effectively use calendar spreads wherein you buy in one contract and sell in the other contract. The idea is not take a view but to capitalize on mispricing. Both these strategies work effectively in lacklustre markets. So, the next time you find the markets literally going nowhere, you need not sit and blame the markets. You can actually pick up your bag of option tricks and actually make money out of such lacklustre markets.