Time for the options trader?

Last Updated: Mon, Dec 31, 2012 04:30 hrs

The Nifty has been stuck in a pattern of range-trading between 5,825-5,965 for weeks. There's a fair chance of a breakout or a breakdown in the January settlement. If the market continues to mark time through January, it could break out or break down, in February or March.

Apart from timing, one doesn't know the direction in which the index will finally move out of the range, though there is an upside bias since the long-term trend appears positive. As and when the range trading pattern breaks, one can expect a move of at least 100-150 points till 5,700 or 6,100. The near-month futures is likely to trade at a premium of 30-50 points to the underlying index – all the prices here are given in terms of the underlying product.

There are several ways to try and profit from this situation. The trend-following positional trader will keep a stop-loss at somewhere between 5,750-5,800, and hold a long futures position. This will gain if there's a breakout and lead to limited losses on a breakdown. If the stop loss is hit, the trader will have to decide on simply exiting or going short. If it isn't hit, and there isn't a breakout, the trader will roll over the futures position into February settlement.

The counter-trend trader will hope the index continues to range within 5,825-5,965 and seek to pick up small profits inside the range. He will short every time the index rises above, say, 5,935 and go long if it drops below, say, 5,850. Each of these trades will be short term. The brokerage will be significant and there will have to be tight stop-losses. The trader may pick up a series of small 30-50 point profits. As and when the range-trading pattern breaks, he could suffer a major loss. If there are several false breakouts or breakdowns, he could lose significant money on each whipsaw.

An options trader has the flexibility to handle breakouts, breakdowns and continuation of the range trading pattern. If he thinks the index will continue to range trade, he can sell options distant from money or take more complex butterfly spreads.

If he thinks there will be an upside breakout, he can buy naked call options or take bullspreads, limiting potential gain but also potential loss. He can take bearspreads, or buy naked puts, if he thinks the index will fall.

He can also take long straddles or long strangles, which will gain on either breakouts or breakdowns. If option positions are taken far from money at say, strikes like 6,100call and 5,700put, the premiums are low. A long option position has clearly defined losses and potentially unlimited gains. Options can often gain several multiples of the premium paid. The risk is also higher in that the entire premium would be lost if there's no breakout or breakdown in January.

Of course, a similar position can be opened in the February settlement if range trading continues through January. If range trading continues in February, the situation could be repeated in March. The option trader might, therefore, need to gauge if the payoff will be enough to over-compensate for several rollovers. It could do so, if the eventual move is big enough and the strike prices at which he buys options are sufficiently far from money and, hence, premiums are cheap.

It's tricky, weighing the pros and cons of these possible strategies. The positional long futures trader has a directional bias. But he pays the least brokerage and has limited losses. His returns could be pretty good.

The counter-trend, short-term trader pays a lot of brokerage. But he could also make a sequence of small profits that eventually add up to impressive returns. He has to hope the range trading will last long enough for those small gains to accumulate. He must watch out for when the range trading pattern breaks.

The option trader could make a huge return regardless of directional trends when the range trading ends. But he could also lose the most money if he must repeatedly roll over.

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