There are many who believe that the current up-move in stock prices will not last for long. Here are two option strategies to help traders who believe as much. The objective in both cases is to take advantage of the negative view and yet cap the upside risk.
The Indian stock market has been starved of positive developments for sometime now. It was, therefore, not surprising to some when the stock market climbed up, perhaps, as a response to the ruling party surviving the trust vote. There are, however, many who believe that this upmove will be short-lived. This poses some important questions. For one, should short sellers cover their positions? For another, can long-term investors take advantage of their negative view in the short term?
This article discusses two options strategies that these traders/investors can employ. The first strategy recommends taking profits on the short futures position and switching to puts or put-spread. The second is an income-enhancing strategy and employs covered call-write on an underlying that forms part of the core portfolio.
Suppose a trader had short-sold Nifty futures at 4825. She is now wary of the up-move but is worried that her profits will be eroded if the Nifty spot index continues to move up. What should she do?
One alternative is to cover the short position and take profits. But the trader suffers from decision regret. What if she covers her shorts and Nifty declines thereafter? The pain from a wrong decision - to cover the short too soon - will be hard to bear. A trader knows upfront that she will suffer from decision regret. So, she will not want to cover her short position. Yet, running the naked short poses high risk.
The trader can draw some solace from the fact that the options market provides an optimal strategy. The trader can cover her short position and take profits. She can then use some profits to buy August Nifty puts. This way, her initial capital will not be at risk. And the puts will be set up to profit from her negative view on the market. The trader should choose the strike that is relatively cheap in terms of implied volatility.
Most traders may not want to pay 125-150 points to set up long put position. Such traders can consider rolling into a bear put spread. Such a spread is set-up buying a higher strike put and selling a lower strike put. This is done to subsidize the cost of the long-leg; the premium gathered from the short-put can be used to buy the long-put.
The problem is that the short-leg will not fetch sizable premium when Nifty is moving up. The reason is that the market will then price the up-move as more probable than the down-move.
The strategy would be to first buy puts but wait till Nifty moves down to sell a lower strike put. The short puts will then carry higher premium for two reasons. One, the turn in the Nifty index will increase the underlying volatility. The higher volatility makes options more valuable. Two, demand for puts will increase as more traders will now perceive a down-move more likely.
The trader should sell a strike that is close to the support level. That way, the short option will be worthless while the long option will expand to its fullest if Nifty closes at the support level on expiry date.
Consider an investor who follows a core-satellite portfolio structure.
Suppose the core portfolio has exposure to large cap stocks. The investor can consider selling Nifty calls against this portfolio. Assume she sells the August Nifty 4700 calls.
If Nifty spot index moves up, the calls will also move up, resulting in mark-to-market (MTM) loss. But the trader’s core portfolio would have also moved up in value.
There are two ways to handle this process. One, the trader can pay the MTM in cash. Two, she can sell some underlying that she believes will pull-back after the near-term up-move ends and use the proceeds to pay the MTM loss.
If the trader decides to choose the second alternative, she will have to buy back the stock at a later date. Choosing not to do so will change the portfolio composition and may subject the portfolio to unwanted investment risk.
If the Nifty moves down as the trader expected, she can cover the short call at a lower price. Covered call-write is an income-enhancing strategy that wants the option to expire worthless so that the trader captures the premium.
This article discussed two strategies appropriate for those who believe that the current upmove will not last for long. It is important to understand that the cash-settled market design enables traders to set up a covered call-write without the risk of the underlying being called away. There is a caveat. As options carry non-linear payoffs, short-legs are more risky than long options. Traders should beware of this factor before setting up related positions.
B Venkatesh
(The author is an investment strategist. He can be reached at enhancek@gmail.com)
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