Nifty Options
My favorite contract to trade is Nifty options. I make positional trades (I am less on the intraday front) with option spread trading strategy, the explanation to which follows. Options contract have a unique characteristic of limiting the risk to what your appetite is when you trade overnight. By this you can manage your risk/reward ratios as per your need and not loose what you cannot afford to. I mentioned in the previous contest that I limit my risk to 1-2% of my portfolio.
"Learning to accept the risk is a trading skill – the most important skill you can learn… When you learn the trading skill of risk acceptance, the market will not be able to generate information that you define or interpret as painful." – Mark Douglas
Why options?
For instance, you buy a put option on Nifty at a strike price of 8000 when the index is priced at 8200. The put option cost Rs 60 to you. So, your risk is limited to 60*75=Rs 4500. Now even if the options expire worthless the worst you can lose is Rs 4500 on the contract. This is a simple option trading technique (not the one I use). I will explain how I place the trades going forward.
Why not stocks?
One can limit the risk on purchasing stocks for intraday, but you cannot limit your risk when making positional trades. It may happen that the stock you bought last day made a gap down opening the next day and you cannot control your losses. For instance, suppose on the day before the Brexit polls were counted you bought TATASTEEL at Rs.334. You thought that when the stock reaches to level of 320 you will sell the stock. But, the very next day the stock opened at Rs.307.1, leaving you at large uncontrollable losses.
Why not futures?
The same problem arises with futures. Although it has a merit as against the stocks that you can play on the downside, but one cannot control the overnight risk. Options are the only instrument which can control overnight risk.
Why option spreads?
The trades I place are option spread trades. For instance, with the basic technical analysis I have a feeling that the markets are moving down. The index currently is at 8300, I would buy 8200 PE and sell 8100 PE. The strategy is called Bear Put Spread. A similar strategy on the long side is a Bull Call Spread.
At the start of April, I shared a similar trading strategy on my facebook page, the link to which is https://www.facebook.com/alphadesire/posts/1672665286329895. In this trading strategy, I had bought 7600PE @ 63 and sold 7400 PE @ 30 when Nifty was priced at 7713. These are the steps that I follow:
Knowing the Trend: Ever since the start of 2015 nifty was trending downwards in a channel. I expected the trend to continue and as the index reached towards the top of the trendline & at 61.8% Fibonacci retracement at around 7760 it made a strong case to be on the short side. Moreover, the index was just going to reach 200 SMA which tends to be a strong support or resistance historically.
Risk appetite: As mentioned, option have a unique characteristic of limiting the risk which I can tweak according to my appetite. So, for instance, I had a portfolio worth 1 lakhs and I wanted to limit the risk (at maximum) 2.5% of my portfolio, i.e. Rs 2500, I had two options:
To buy only 7400 PE at 30
To buy 7600PE and sell 7400 PE
Why did I not select the 1st option? Well, I would have saved brokerage, moreover I would not require any margin as such. But, the 7400 PE would have less probability of being in the money (lower the delta, lower the probability of the option being in the money; for more information on delta click here) and if the market moved sideways, then I would have lost all of it. For me to breakeven at 7370, the markets would need to fall 4.44% from the current market price, which is way too much to ask for.
But in the 2nd strategy, I would have higher probability of being in the money. Yes, I would have limited the upside potential because as market would move below 7400, I would make no money. In this case the breakeven would be 7567 and I would only require the markets to fall by 1.89% to breakeven.
Payoff calculations: The risk and reward for the above strategy is as follows:
Breakeven
7567
Maximum Profit
167
Maximum Loss
33
Risk/Reward Ratio
5:1
Here is a table calculating profit/loss at different maturity price:
Maturity Price
Value of 7600 PE
Value of 7400 PE
Net Profit/Loss
7700
₹ 4,725
₹ 2,250
₹ 2,475
7600
₹ 4,725
₹ 2,250
₹ 2,475
7567
₹ 2,250
₹ 2,250
₹ 0
7500
₹ 2,775
₹ 2,250
₹ 5,025
7400
₹ 10,275
₹ 2,250
₹ 12,525
7300
₹ 17,775
₹ 5,250
₹ 12,525
Pay off diagram:
By this strategy, I have limited loss to Rs 2475 and my profit potential to Rs 12525. Now, I do not have a hard and fast rule for holding the instruments till maturity. So selling the holdings is an individual’s call. And yes, for this I would require margins of about Rs 40,000, but I don’t mind if I have a better risk/ reward ratios to compensate. Surely, I have limited both the upside and downside potential, but I prefer reaping small profits regularly, rather than reaping huge profits at once.
“Add smaller and smaller amounts on the way up. Keep your eye open at the top” – Ed Seykota
Please Note: This is the strategy I executed in the past and is just for illustrative purpose to explain why nifty options work best for me. I trade in other contracts/scrips too, but options contract is my favorite.