Traders have suffered large losses this year because of what technical analysts call “whipsaws”. A whipsaw is a price movement where the stock or the index goes up or down and then reverses direction. Such whipsaws make it difficult to set-up directional trades. And even when directional trades become profitable, the sharp pull-backs and throw-backs wipe off most of the unrealised gains.
This article discusses two strategies that can help traders realise profits and yet carry exposure for further gains. One strategy involves initiating a position with long underlying, then taking profits and using some of the gains to buy calls. The other strategy involves first buying lower strike calls, then selling the contract and rolling into higher strike calls.
Trade set-up
We will take a view on Reliance Industries as on March 24, 2008. On that day, the stock hit a low of Rs 2,120 and closed higher at Rs 2,200. We chose this day because the stock hit that price level for the fourth time since January 21 and yet failed to break-down.
We will take a view on Reliance Industries as on March 24, 2008. On that day, the stock hit a low of Rs 2,120 and closed higher at Rs 2,200. We chose this day because the stock hit that price level for the fourth time since January 21 and yet failed to break-down.
This price movement leads the trader to believe that the stock has strong support at Rs 2,120. The trader further takes a view that the stock could move up to Rs 2,400 before expiry of the April contract. The initial trade set-up would be long stock or futures or calls.
Stock: Rolling into calls
Suppose the trader buys 75 shares of Reliance at Rs 2,250 on March 27. After touching an intra-day high of Rs 2,400 on April 2, 2008, the stock moves sideways for two days. The trader sells 75 shares at Rs 2,375 on April 4. The position has a realised profit of Rs 9,375 (Rs 125 per share).
The trader decides to deploy some of the profits to buy at-the-money (ATM) or out-of-the-money (OTM) calls. Suppose she buys one contract of April 2500 calls for 35 points. This leaves her with realised profits of Rs 90 per share. Besides, the call will generate profits if the underlying moves up.
Sure enough, Reliance Industries canters upward by mid-April. Our trader sells the April 2500 calls at 55 points on April 11. She, therefore, generates a total profit of Rs 10,825 (Rs 125 and Rs 20 times the quantity size of 75).
Strategy: Why optimal?
To understand why this strategy is optimal, consider the following. Suppose the stock had declined to Rs 2,300 by mid-April. The April 2500 call would have been worth 20 points. Assume the trader sells the call. The loss on the 2500 call would be 35 points while the profit on the shares, 125 points. The total profit would be 90 points. If the trader had instead sold the shares during the pull-back, she would have gained only 50 points.
To understand why this strategy is optimal, consider the following. Suppose the stock had declined to Rs 2,300 by mid-April. The April 2500 call would have been worth 20 points. Assume the trader sells the call. The loss on the 2500 call would be 35 points while the profit on the shares, 125 points. The total profit would be 90 points. If the trader had instead sold the shares during the pull-back, she would have gained only 50 points.
Then, consider another scenario. What if the stock pulled-back all the way to Rs 2,120? The trader would have most likely stopped the position. Taking profits on the underlying and setting up a long call position instead helps the trader participate in the upside.
This strategy embraces the traders’ behavioural psychology. By selling the shares, the trader can mentally rest having taken some profits from the trade. Importantly, initial capital is no longer at risk.
Calls: Rolling into higher strike
Suppose the trader decides to initially buy calls instead of the underlying. Assume the trader buys the April 2500 call on March 24 at 45 points. On April 2, 2008, the trader sells the call at 75 points, for a 30-point profit.
Suppose the trader decides to initially buy calls instead of the underlying. Assume the trader buys the April 2500 call on March 24 at 45 points. On April 2, 2008, the trader sells the call at 75 points, for a 30-point profit.
The trader now uses some of the profits to buy deep OTM calls. Suppose the trader buys the April 2600 call for 13 points. She has locked-in to 17 point-profit and has set-up a position that has potential for further gains. The trader sells the April 2600 call at 30 points on April 11 for a 17-point profit. In all, the trader makes 34-point profit on smaller capital.
This trade is optimal compared with running the April 2500 call till April 11. Why? Remember, options are wasting assets. If the stock moves sideways for couple of days, the April 2500 call will lose time value, which will wipe out some or most of the unrealised profits. Taking profits and rolling into a higher strike call helps the trader capture time value.
Conclusion
The trade set-ups discussed above shows how traders can realise profits and yet have exposure to further upside movement. Rolling futures into calls is similar to rolling stock into calls. Puts can also be used for set-ups that profit from downside price movements.
The trade set-ups discussed above shows how traders can realise profits and yet have exposure to further upside movement. Rolling futures into calls is similar to rolling stock into calls. Puts can also be used for set-ups that profit from downside price movements.
It is important to have a trading plan before initiating such strategies. Remember, switching from shares to calls or from lower strike to higher strike option is not an after-thought but a well-planned trade.
B. Venkatesh
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