All over the world especially the US, volatility trading is very popular. Its has a lot of benefits. For example if you have a big portfolio of stocks and you feel the stock markets in general may head south (going down) and the volatility will increase, you can buy the volatility futures. In that way if it increases, you can make money.

What is Volatility:

Well volatility is nothing but the “fear factor” in the market. If there is a lot of fear, like a war going on, or some kind of big news coming the volatility usually goes up. If there is any kind of uncertainty in the markets, in the country of the stock market or the world itself (like war between two countries, big bank declaring bankruptcy or any country’s economy showing signs of recession etc), the fear factor will increase.

If fear factor (the risk factor actually – the risk of investing in the stock market) increases, the volatility will reflect that. If volatility increases the option prices – calls and puts – both will increase. If volatility decreases the option prices – calls and puts – both will decrease.

It should be quite obvious now that since most of these are bad news, the fear factor increases and the markets tumble. During normal times volatility calms down and stays in a range.

You can get the current India volatility also known as India VIX here:

http://www.moneycontrol.com/indian-indices/india-vix-36.html

Note: Sometimes the volatility may increase even if the markets are going up. For instance the recent general election in May 2014. Up to the election results’ dates the volatility just kept increasing. WHY? Because the markets had no idea which government will come to power. This was a big news. There was an uncertainty in the markets. Whenever there is an uncertainty the volatility will increase.

Since the market was hoping that BJP will come to power, it was going up – but fear was also increasing day by day – so the volatility was also increasing.

But in most cases, the markets and volatility go in opposite direction. In the US, you can also trade options on volatility. There the traders buy call/sell puts if they think the markets will fall and volatility will increase. If that happens their portfolios worth goes down, but they recover some money from the volatility calls bought or sold puts.

A 10% jump in volatility is very normal if the news is bad. Since it is leverage, the traders make good money.

It was a long demand of the market participants in India to bring in the volatility trading.

In Feb 2014 Nifty introduced volatility trading in their platform and officially the first day of NVIX trading was on 26-Feb-2014. Right now only futures can be traded. After some time they plan to introduce option trading on volatility too. I am eagerly waiting for that. 🙂

Here are some of the contract specifications taken from http://www.nseindia.com/:

Underlying: India VIX Index
Symbol: INDIAVIX
Futures name: NVIX (not Nifty VIX Futures)
Can be traded on: NSE
Instrument Type: FUTIVX
Lot Size: 550 (Revised on circular dated June 24, 2014)
Quotation Price: India VIX Index * 100 (means if VIX is 15.56 the quote will be 15.56 * 100 = 1556)
Contract Value: Minimum Rs. 10 lakhs at the time of introduction
Tick Size: Rs.0.25
Trading Hours: 9:15 AM to 3:30 pm
Expiry Date: Every Tuesday of the week
Contract Cycle: Weekly – 3 contracts
Contracts: Near, Mid & Far
Final Settlement Procedure: Cash Settlement
Final Settlement day: All open positions on expiry date shall be settled on the next working day of the expiry date (T+1)

How does this help option traders in India?

If you are an option buyer, volatility is your friend. But if you feel that volatility may decrease, your option prices may decrease in value. So you can sell NVIX. In that case if volatility decreases, you will make a loss in the options bought but will make a profit in the NVIX sold.

Similarly if you are an option seller, volatility is your enemy. If it increases, your options will also increase in value and you will be making a loss.

In that case an option seller can buy the NVIX futures. If volatility increases, you can make a profit in the NVIX futures, but you may make a loss in the options sold.

Important Disclaimer: Please remember that inverse may also happen. For example you bought a call option and sold NVIX. It can happen that volatility may increase and the index also falls very fast. In that case you will be losing money in both the NVIX futures and the calls bought. Why? Because the volatility is co-related to Nifty. You have bought a call and Nifty is falling – upto a certain extend the volatility increase may help, but if the fall is steep no volatility can help you. To some extend it may, but for that to happen the volatility will have to explode – increase by a huge percentage points. Under normal circumstances that rarely happens. You may lose money in both NVIX and calls bought. Trade with caution. You are better off buying a debit spread.

I am big fan of conservative trading. All my positions are properly hedged. This is one hedge position in my view not a great hedge. If there is a possibility that I will lose money in both the positions, I run miles away from that trade.

However just for reference I am writing here trades that can be done as hedging your options portfolio with NVIX:

Call Option Buy : Sell NVIX
Put Option Buy: Sell NVIX
Call Option Sell: Buy NVIX
Put Option Sell: Buy NVIX
Credit Spreads: Buy NVIX
Debit Spreads: Sell NVIX
Iron Condors: Buy NVIX

Investors can also straight buy/sell NVIX if they have a view. For example if an important news is awaited, you can buy NVIX, and on the day of the news before the news declared, book your profits and then sell NVIX.

Caution: Timing is not that easy.

Lets see how much risky is NVIX trading:

NVIX Futures price is the current volatility * 100 + some premium.

For example if the volatility is 18.1325

18.1325 * 100 = 1813.25 + 1.5 premium (approx) = 1814.75

Lot size is 550 = 1814.75 * 550 = 9,98,112.50

Ticker size is: 0.25 (If volatility increase by 1 ticker it is equal to 0.0025 and NVIX will then increase by 0.25 (0.0025 * 100))

Lets suppose volatility increased by 0.0025. So NVIX also increased by 0.25.

= (1814.75+0.25) * 550 = 9,98,250.00

Lets check the difference:

9,98,250 – 9,98,112.50 = 137.50

You can also get this figure by: 550 * 0.25 = 137.50

Which means for every ticker move a trader makes or loses 137.50.

Please note that lot size can differ from time to time. NSE will release the circular when the lot size will change. Currently lot size of NVIX is 550.

How volatility is calculated?

Its a complex mathematical formula. But in short it is computed by NSE based on the order book of options. All options and not just Nifty options.

Only near and next months bid and ask quotes are taken. If there is too much of sudden demand of options, VIX increases. If everything is normal VIX will reduce. The VIX that you see is the perception of the markets for the next 30 days.

When the VIX is high you will see that markets will have wild swings. It will go up and/or come down swiftly. During these times it gets very difficult to predict market direction.

When the VIX is high, most traders sell options. When its low they buy it. But today you can make more money by selling VIX futures if you think the volatility will calm down, and buying it if you think it will go up.

Some other important things on volatility:

1. VIX has a strong co-relation to Nifty movements. If Nifty falls, VIX increases and vice-versa.

2. India Vix has a mean of 26.65 and a median of 23.83. VIX reverts to mean, so option traders can make a note of it.

3. VIX is always expressed in percentage terms. It can never be lower than 0 or greater than 100.

4. Its easier to predict volatility. For example if a news is pending the volatility will increase until the news is out. Buy before news, sell after it.

5. You will need around 2 lakhs rupees as margin to buy/sell VIX Futures. Most retail traders do not trade VIX futures. One lot value is almost 10 Lakhs. But if your prediction is right, you can make amazing returns. However losses can also be huge.

Disclosure: In full disclosure I have never traded NVIX (VIX Futures). Although I have the intention to trade VIX options if they are introduced in India. This article is written for people interested in trading VIX. I am a conservative trader and am happy trading Nifty options. I like to take small profits and small manageable losses. Please use your own discretion before trading VIX Futures.

Some important references:

http://www.nseindia.com/content/indices/India_VIX_Brochure.pdf
http://www.nseindia.com/content/circulars/FAOP25802.pdf
http://zerodha.com/z-connect/queries/stock-and-fo-queries/trading-india-vix-simplified
http://www.business-standard.com/article/markets/10-things-to-know-about-india-vix-futures-114022600305_1.html
http://www.moneycontrol.com/news/market-news/how-will-vix-futures-work-iisl-answers_1045014.html
http://www.moneycontrol.com/news/market-news/tradingvix-futures-to-kick-off-tomorrow_1047948.html

Long strangle is very rewarding if market moves in any one direction rapidly. The last one word is very important – the market has to move in any one direction – up or down – RAPIDLY or Fast. If it does the long strangle trader will make unlimited amount of money else the losses are limited.

I actually hate this “unlimited amount of money” thing. I mean really? When was the last time you made unlimited amount of money? Somewhere a trader will book his profits. Why these so called experts say on this, and some other strategies like options buying can make unlimited amount of money, is what I fail to understand.

Unfortunately technically I have to write this that long strangle makes unlimited amount of money and losses only limited amount of money. Please don’t fall for this trap though. Predicting market direction is difficult if not impossible. However you can see that with this strategy you only have to predict if the markets will move fast and deep in one direction – the direction itself is not important. So here there are some advantages. We will look at that later.

How to Trade Long Strangle strategy:

1. Buy option or options on the Call side any strike price.
2. Buy the same number of options on the same underlying Put side any strike price different than Call strike price.

Note: Most traders buy out of the money options for both calls and puts. How far depends on the trader.

Risk: Limited
Reward: Unlimited

So lets say if you feel Nifty will move within a few days very fast in one direction, due to the upcoming budget on 10th of July, 2014 – you can buy an OTM Call option strike price 7800. And at the same time you can buy a OTM put strike price of 7200. Nifty currently at the time of writing this article is at 7504. Once the trade is complete you just bought a long strangle.

Lets go and check their prices:

31-July-14 CE 7,800.00 56.00
31-July-14 PE 7,200.00 42.00

Once you have put the long strangle trade you should know your break even point.

How to calculate the break even points of long strangle?

Add both the points of call and put option. Now when selling you should get the same points – and that is your break even point.

Since usually traders do not leave this position till expiry I will not calculate the break even point till expiry. In our example our break even is: 56+42 = 98. If you need to make a profit, you need more than 98 points in total while selling the call and the put option.

Disclaimer: By the time this goes live on my blog these prices may have changed. Please do not trade this strategy just because it is mentioned here. This is for example only.

Note: You can literally buy ANY strike price of these options. If they are of the same strike they will be technically called Long Straddle. Both the Long Straddle and Long Strangle will profit if markets take a fast direction either side. However the difference lies in the money you have to pay upfront to buy these options. In a Long Straddle you will have to pay more as either both of the options will be ATM or one of them will be deep in the money. However with long strangle your costs will be less as usually traders buy options out of the money for both the calls and puts. This will limit your risk.

Imagine you bought options closer to the money – you would have to pay more for the strangle. And if the markets did not move and stayed in a range – you will lose much faster than someone who bought the out of the money options. On the other side if markets did not make a significant move but still made a good move – there is a chance that the trader who bought options closer to money will make a profit, but the trader who bought the OTM options may lose money.

WHY?

You see options closer to the money will move faster than the options that are further out of the money. So if the markets are going up – the closer to the money call options will increase in value faster than the OTM calls. Of course the near the money puts will also be losing money fast, but this strategy is profitable only when the market move is significant. If the value of one option moves faster than the one which is losing money – the trade makes money.

If the options are deep out of the money it needs a big and substantial move for it to be profitable. If that move does not happen – the trade will lose money. If the move is indeed significant the trader who bought the OTM options will make more than the one who bought the options closer to the money. Simply because there is not much to lose in any of the option.

It takes us back to the question. Which options to buy when playing the long strangle?

Very tricky to answer this one but I will try. First of all you should trade this strategy only when the markets are expecting major moves. On top of that you should have in mind a risk that you are willing to take. Do not over trade just because you think the markets will move. It may but you may still lose money.

If there is a really major news like general election results, budget declaration, or may be a war between two or more countries – you should buy deep out of the money options. Why? Because the markets may give a knee jerk reaction. In such a case OTM options in long strangle trade will be more profitable.

If the news is as simple as a stock’s quarterly earnings reports or IIP data – you should buy near the money options. Because there may not be a significant move, but a 3% or more should do the trick.

Another note: If trading this strategy please do not wait for unlimited income. There is no trap like unlimited income. You should have a target in mind. Once it is reached – just close the trade. In fact once the news is out you should close both the options – calls and puts – either in profit or in loss. Don’t be greedy. Some traders I know only close the option that is losing money. Well you don’t know when the markets will take a turn. In that case all your profits may vanish and you have already taken a loss in the other option. That’s a bad decision. Close both the trades as soon as your profit target is reached or the stop loss is hit. If markets moved further do not feel bad that you closed the trade earlier – you made a profit and you should be happy.

You know what I do once I close a trade either in profit or a loss. I simply forget the trade. If there was something to learn I write it down in my research papers but I do not look back and try to figure out had I waited what would have happened. That for me is a waste of time.

So what I do if markets do not move the day of the news? I simply close the options at a small loss. I do not wait for the markets to move. If they haven’t moved after the news, they will not move because you have traded long strangle. Just close the trade.

Similarly if markets move very strongly the news day I close the trade before the European markets open and be happy with my profits. Then I start thinking about my next trade.

Very Important Note:

Long Strangles are highly dependent on volatility. Before the news volatility is usually high. Unfortunately because of this the option buyers have to pay a high premium to the sellers. And here is some more bad news – once the news is out there is no more anxiety, therefore the volatility crunches. This means the values of the options erodes on the day of the results.

Which means a long strangle buyer will have to fight not only movement but also volatility. How tough is that?

Lets take an example on the effect of volatility on strangles:

Due to Indian’s general elections results to be declared on 16th May 2014 a trader took a long strangle position on 14th May 2014.

He decided to buy far OTM calls and puts as the day of the results can give the markets a knee jerk reaction. For simplicity lets take closing prices.

On 14th May 2014 Nifty closed at 7108.
India VIX (the volatility) was 32.40.

Lets suppose he wants to buy 5% far OTM calls and put options:

7108 + 5% = 7500 CE (approx)
7108 – 5% = 6700 PE (approx)

Lets get the prices:
7500 CE: 86.00
6700 PE: 84.00

Lets suppose he bought 2 lots each side:

Total investment: (86 * 50 * 2) + (84 * 50 * 2) = 17,000.00 (Rs. Seventeen Thousand)

Now lets see what happens on the morning of the election results day 16th May 2014:

Nifty makes a high very fast of 7563.
India VIX crushed to 24.29. A 25% drop.

Now lets see what happens when the markets made a huge leap and volatility crushed around 10 am in the morning when the trader decided to close his position:

7500 CE made a high of 232.
6700 PE made a low of 6.

Lets suppose the trades closed the call at 210.

Lets see how much he gets back when selling the long strangle.

(210 * 50 * 2 ) + (6 * 50 * 2) = 21,600 (Rs Twentyone thousand six hundred)

Total profit: 21600 – 17000 = 4600.

ROI: (4600/17000) * 100 = 27.05% in 2 days. Isn’t this a great return?

Well frankly I know many people who made more than this including myself. 🙂

On 14th May 2014 the near to the money calls were so costly that I think probably institutional investors only bought them. For example LTP of 7200 CE was 196 and LTP of 7000 PE was 168. Total points 196+168 = 364. For two lots your total investment would have been 36,400. I am personally not in favor of taking this much of a risk. Of course you can trade with one lot. The more costly the option prices – the more the risk.

Did you notice one thing? Volatility crushed by 25% still long strangle traders made money. This was possible because Nifty moved significantly in one direction raising the prices of the calls to even defeat the volatility. If Nifty stayed there or would not have moved significantly, the option prices would have reduced dramatically and sellers would have won.

As I told you earlier, volatility cannot beat the speed of the movement of the stock. If its significant, volatility has a small role to play, if not for long options it can be a killer.

Lets conclude this discussion with important points:

1. Long Strangle is buying both call and the put option of the same underlying but different strike prices.
2. Usually traded before an important news or event.
3. Do not wait till expiry. Once the news is out close your position either in profit or a loss. You can wait for maximum of two days in extreme cases.
4. Long strangle should not be traded too often as option buyers mostly lose money.

If you reached here looking for stock options trading tips from an advisory service provider, you have come at the wrong place. But I request you to please read this article, it will save you from a lot of hassle.

If you are in a hurry to know, I am a trader like you, but I do not provide advisory service on stock/nifty options or any other stock market related trading. Why? Because I trade them profitably, I do not need anyone’s help.

Ask yourself this question first – “Why should I pay someone to trade the stock markets? Can’t I learn some great strategies and make money myself.?”

Yes you can.

People with knowledge make money in the stock markets, and who lose? Those who look for tips providers or those who speculate the markets.

In my early stage of trading I was also one of the guys looking for stock option trading tips and paid a few companies to make money on the stock markets. The result? I lost money. On the one had I paid them almost Rs.40,000/- in six months duration to give me some tips, on the other hand I was also losing money trading their tips. I lost almost Rs.700,000/- (seven lacs) trading their tips. How much worse can that get?

However things have changed now and I am a happy option trader. I offer a course a on trading options profitably, but my simple advise to you is this – even if you do not take my course – please do not pay anyone to get tips. They will not work and you will lose money – Guaranteed with a capital G.

These people will take money from you and put it in a fixed deposit in some bank. While you keep losing money, they are getting a guaranteed return of 6% or more on your money. Stop looking for them. They will not make you rich, rather you will make them rich.

When I lost money trading their tips, you know what I did – I started trading EXACTLY OPPOSITE of what they were sending me as tips. So if they had a buy call on some stock, I would sell it. If they asked me to sell, I would buy it. Interestingly here too I lost money over a period of one month. And these were good reputed companies advertising their stuff all over the internet.

So what did I learn from it? That they send us any random tip they want to send. Since stock markets are speculative game, there is a 50-50 chance that their tips will work. Over a period of time you will see that 50% of their tips hit the target and the rest hit stop loss. So your net income is loss because for every trade you pay a brokerage and also the fee to the tip providers.

There is another problem. These people will send you an on-time SMS that may take a few seconds to reach. You will see that SMS, take time to understand it, call your broker or search for that security on your demat account online. You then look for the price they have sent only to discover that the stock or the option has moved away from that price and you will be unable to trade that stock, or the option price may have changed in the meantime. Same thing happens when you call your broker. Yes you may put a limit order, but who knows if your trade will go through.

Intraday means you cannot miss that stock with even .1 point because you lose money. Usually for stocks profits are booked at 1% or less, 10 points for Nifty options. If you cannot get the trade with that exact price, you have already lost some money. Compound this with losses and you are losing more than you are making. You will then stop giving money to the advisory service provider.

Other problems are there too. Sometimes you will find that there is no internet connection, or the broker site is down. These people who send intraday stock tips usually send 5-6 trades a day. They advise you to trade all the trades they send. If you miss one trade, you will be scared to trade the other trades as that is what they have advised against.

If Internet is down, you will call your broker. His phone may be busy – and your trade is gone. Believe me brokers are least bothered with your account. They want you to trade more often so that they can make money. Sometimes they will do mistakes and then reverse it immediately. Both the time there is a transaction and you will lose money on brokerage even if they reversed the trade at the same price. Note that reversing immediately is mostly losses because of the difference between ask and bid.

Intraday stock trading means you have to leave your job and trade. I strongly advise against doing so. Do not leave your job. It is not easy to make money from the stock markets. If you try too hard, you will lose money – guaranteed.

If you don’t have time to do full time Intraday trading I would suggest start putting money in installments in few good mutual fund or stocks. Do not buy in a bulk – that’s speculation – just buy a little amount every month. And more when the stock falls.

Stock option tips providers will also sometimes play very cheeky and cheap tricks like price inflated/decreased of an option. When it reaches your mobile, you will think that option price may have reached there and you got the SMS late. In reality your tips providers are stealing a point or two to show profits.

For example if YesBank option is going for 10, they will send you message to buy at 9 (best buy price) and after a few seconds will send a SMS to sell it at 10 (best sell price). In their view they made Rs.1000/- for you but in reality the trade was impossible. (1 lot value of YesBank option is equal to 1000 shares.)

Some stock option trading tip providers send SMS before that option reaches that price. That is a good way of sending tips, but its my personal experience that you will still lose money as its hard to make money buying options.

Sometimes in highly volatile stocks you will see that as soon you get a message to buy an option the target is hit and they send an SMS that the target is hit. You will not be able to trade that call.

Now try calling them. These people have an amazing bad service. They never accept that they are bad tips providers. In fact on the contrary they will blame you for not being able to trade properly. You will feel very low, humiliated and stop trading their tips even if you have paid them for a month or more. Your money is lost plus you lost money trading their tips.

You will be highly disturbed too. Your boss has given you a deadline and these SMS will keep coming and keep disturbing you. Will you trade or will you work in your office? On top of that since to get their services you have opted out of DND (do not disturb) service, you will also start getting unwanted unsolicited calls and messages on your mobile phone.

After sometime your whole life will get so irritating to the point that you will stop trading altogether. You will lose interest in the stock markets. Unfortunately you have lost interest in one of the best ways to increase your wealth.

You know what, this has happened to me, therefore I was able to write this article with so much precision.

But I had no other place to go and make money – so I started learning about options. I will not elaborate my story here, you can read about that here.

The point I want to make here is why you cannot learn to trade options? They are not something from the moon. Its easy to make money from them if you know how to trade them. I have been doing this regularly since 2011-12. I can teach you to trade options and make money.

These are all easy trades. No these are not intraday trades, all are positional trades. You may have to trade only 2-4 times in a month and carry on with your job. These are all protected options means either you make limited profit or limited loss. You do not even have to predict the direction of the markets. You do not even have to monitor the trades every second. Just once a day is enough. You do not even need to know technical analysis. And you will still make money trading options. How much easier can it get?

Learn stock option trading yourself, forget the tips provided by the advisory companies and be confident and make money.

Short straddle is a strategy when a trader sells or shorts calls and puts of the same stock, same strike and same expiry. It is a risky trade but can be managed.

Short straddle is exact opposite of long straddle. It is a very risky strategy as the losses can be unlimited. Please do not try this strategy unless you are an expert. You can try this if you have strict stop loss in the system. But in India we cannot put a GTC (good till cancelled) orders. So here in India it becomes a very risky strategy.

What is Short Straddle?

A short straddle is a trade when a call and a put are shorted/written/sold of the same stock/index, of the same strike price and of the same expiry.

For example as of writing Nifty today closed at 7367.00

Now let us suppose a trader feels that for the next 30 days Nifty will not move much, so he plans to sell a June 2014 7400 call and 7400 put. Let us see how much they are available now.

26-Jun-14 CE 7,400.00 142.00
26-Jun-14 PE 7,400.00 136.00

Let us assume he got these best prices and he sold them. Total points = 278. Total cash received in his account: 278 * 50 = Rs. 13,900.00

Do not be happy that this trader has received a huge amount in his account. Now his job is to protect this cash.

I hope now it is clear what a short straddle is. If the trader is lucky it can be a very profitable trade. But how many times were you lucky trading? Can anyone make money trading the stock markets just by luck? No.

Short straddle done. What’s next?

I have written earlier – the trader’s job is now to protect the income received. The first thing he will do is to calculate the breakeven point. 278 was the total points received.

So the upper BE: 7400 + 278 = 7678
And the lower BE: 7400 – 278 = 7122

Hope it’s clear – if Nifty starts to move beyond this range the trader will start to lose money. And he will have to do something very quickly to make sure the losses do not escalate. It is something that every trader should be worried about.

Note: Exact opposite is the long straddle. If the stock moves beyond the break even points the trader will start making money. The short straddle trader will lose and that is the name of the game called stock markets. 🙂

How to adjust a short straddle gone wrong?

1. It’s a very risky trade. In my view you should not trade this at all. But even if you have done – the best way to adjust any trade gone wrong is to take a stop loss. Get out of the trade if it has crossed the break even points or the losses are more than a certain percentage of the credit received. Some people keep this fixed at 50% of the credit received while some keep this at double the cash received.

Taking the above trade as an example:

The trader received Rs. 13,900.00 trading the short straddle. So he will not take a stop loss till the losses are 13,900*2 = 27,800. Once this figure is reached they will close both the positions – the call and the put. Total losses are still at 13,900.00, because from the 27800, 13900 that the trader received will be deducted.

Some traders keep this at a conservative 20% of the cash received. Ideally the stop loss should be kept at the total amount the trader is comfortable losing. You cannot keep it at Nifty Break Even points level or at some Nifty level. Why? Because a short straddle is Vega dependent too.

Lets assume the markets did not move after the announcement. But that does not mean that the short straddle trader is winning. The news could be confusing and the volatility may explode. If volatility increases, both the put and the call will increase in value and the short straddle will lose money.

Note: In reality short straddle is very tempting to play. Usually when a major event is to take palace or some big news is expected in a stock – the market makers will increase the volatility. Why? Because if they don’t, the values of the calls and the puts will be the same as before and for a seller of these options it gets very risky. If you are getting a lot of money for a huge risk you may be willing to take the risk. But if you are getting little money will you take that huge risk? No one will. Therefore to make a level playing field for both the sellers and the buyers the market makers increase the volatility. Moreover trades just wont take place if the calls and puts are not valued attractively before a big news or event. The buyers will not find any sellers.

Now it should be clear its obvious that if the calls and puts are not rightly priced, no one will come forward to sell. In that case if there are no sellers, there cannot be any buyers. So no trade will take place before a major event. Who loses money in that case? The market makers! More trades means more money for the people who own the stock markets and of course the brokers. The owners of the stock exchange want their brokers to be profitable too as they act as marketing agents and get them clients. If they are not profitable they will leave the business and owners of the stock exchanges will also lose money.

This is justified too. Why should a trader take a risk for too little in return during abnormal times?

So short straddle should be played when the volatility is very high and important news is awaited. Once the result is out or the announcement is made – the volatility gets shrunken and the trader makes money because the value of the calls and puts declines significantly.

Both the high volatility and the huge cash receivables is the tempting factor to play a short straddle.

Coming to managing the trade: The best way is to close the trade once your predetermined level of losses is reached. However as said earlier this is a very risk trade. Usually the news is declared when the markets are closed for the day. So you don’t know where the markets will open the next day. One thing is for sure the volatility will get crushed, but you will never know where the market will open the next day and where it will go from there. When they open you may find that markets have already surpassed your predetermined level of losses and therefore you will have to close the trade at a much bigger loss. However if the level is not reached but you feel it may be reached, you can close the trade early too. Your losses will be less.

2. Another great way to manage a short straddle is to buy naked calls or puts depending on where the markets are heading. For example if the news was bad, you can buy closer to the money puts. Remember that now they are available at relatively cheap prices, you can afford to buy them. If the puts are cheaper than the total money received, and if they are ITM than the put sold, you will not lose money if markets go in the same direction. In fact if you buy more puts than the no of puts sold, you will make money. Similarly you should buy ITM calls if there was some good news. But you got to this as soon as possible. Hoping that the markets will not move further can be catastrophic. You have taken unlimited risk. Do not leave this on luck.

3. If buying calls or puts are very costly then you can sell credit spreads against the losing position. For example if the markets are going up after the news, you can sell put spreads. And if markets are falling you can sell call spreads. But this will give you limited profit. And if there is a whipsaw you will start losing money in the spreads sold.

4. Exactly opposite of selling the spreads, you can buy the spreads. Buying spreads will reduce the cost of buying naked calls or puts. But again your gains will be limited. Same as 3 – a whipsaw means you start losing money in the newly bought spreads.

When to trade a short straddle?

As written above, one or two days before a major event is going to happen or some major announcement is to be made on a stock or markets in general. For example, budget announcements or general elections. For stocks it can be earnings report.

For example the India VIX (Nifty volatility) on 15th-May-2014 was around 44 (one year high) and when the general elections results were declared on the very next day – it crushed to around 25. It was still not very profitable for the short straddle traders because the markets open huge gap up of around 4%. People who bought deep ITM calls only probably made money. But ITM calls were very costly. ATM calls were going at around 300. So 300 * 50 = Rs. 15,000.00 was at risk for just one lot of Nifty option. Similarly someone selling a short straddle would get around Rs. 30,000.00. Isn’t this tempting? Still that trader would have lost money.

BTW what did I trade? I did the double diagonals and made small money. 🙂 Better than losing money.

If you stick to my advice, short straddle as a trade should be avoided. There are better trades during these times. Don’t get tempted.

When to exit a short straddle if next day you see that the trade is profitable?

It will be suicidal to wait till expiry. You don’t know where the markets will go in a few days. Even if you are making a small profit, its advisable to exit such high risk trades.

Have you ever tried a short straddle? If yes what was your experience?

Markets usually stay calm therefore most of the times its almost always better to trade an iron condor or credit spreads. However there are times when traders get emotional and start behaving in an abnormal way. These are turbulent times. Markets lose their direction or shoot in one direction or the other. In other words the markets over-react.

This happens when a big news is expected. Like when a company is declaring its quarterly results. Or when some kind of big news like a company’s offer to buy another company. Some times FED decisions affect the markets. This happens a few times in a year. But they do happen. For example in the last 3 trading days Nifty has rallied over 400 points on the anticipation that BJP will form the government headed by Mr. Modi whom the markets thinks to be investor friendly.

Did anything happen in the last few days? No. Did the economy change in the last 3 days? No. Did suddenly the industries are showing a huge profit. No way. Ground realities are still the same they were a few days back, but markets behaved irrationally. Just on a hope the markets rallied. This is where emotions came into play and not rational trading decisions.

Long straddles are played exactly before such times when a huge move is expected in the near future.

How to play a long straddle?

People who keep reading news will know beforehand if any stock or the whole markets will be very volatile in the near future. These people if they know about the long straddle will play that. Remember long straddle or for that any strategy must be played with a strict stop loss or hedging the trade. There is no guaranteed profits – so you need to restrict your losses.

So the long straddle is played much before the volatility actually begins, much before the news comes in. Thus the timing is very important or you may miss the trade.

The Trade:

A trader will buy both call and put option of the same stock, of the same strike price and of the same expiry date. Mostly ATM (at the money) options are bought. But traders can buy any strike according to their view. For example if trader thinks the markets will fall, they may buy a ITM put and obviously that strike will be OTM (out of the money) for the call. Which means they invest less in the call and more in the put.

If markets move in the right direction a trader will make more than a long straddle trader who bought ATM options. But will lose more if markets move against his view.

Technically the number of call options and put options should be the same, but depending on your view they may differ. For example if you think markets may move up, you may buy 2 lots of calls and 1 lot of put. But if you are wrong, you can face heavy losses. And if you are right, you will laugh all the way to the bank.

But most traders play with same number of lots of calls and puts just to be on the safe side.

Important Note: Volatility plays a huge role in deciding if the trade will be profitable or not. Usually before any big news the volatility is very high because the fear factor is very high. No one knows where the markets will go. Due to this reason the volatility is very high. When the volatility is high the premium is also very high of both the calls and puts. Which means the trader will pay more to buy the calls and puts and therefore the break even price will also move away.

For example these are elections time. Results will be declared tomorrow. Today the volatility is 36.77. This is almost near is 52 week high of 39.30 which was also achieved because of the elections. Usually it hovers between 15-20. So as you can see the volatility is very high and the premium of the calls and puts will also be very high. Today there would have been many straddle buyers trying their luck, Today i.e… on 15-May-2014 Nifty closed at 7123. So lets see the prices of ATM calls and puts.

29-May-14 CE 7,100.00: 263.00
29-May-14 PE 7,100.00: 223.00

Which means a ATM straddle buyer today would have paid: (263+223) * 50 = Rs. 24,300.00 for just one lot of call and put.

Lets see if its worth the risk or not.

First lets calculate the break even point:

263+223 = 486. Which means a straddle buyer will only make money if Nifty expires either 486+ points above or 486+ points below.

The break even point if Nifty moves up and expires above 7100:

7100 + 486 = 7586

The break even point if Nifty moves down and expires below 7100:

7100 – 486 = 6614

So the trader will make profit only if at expiry Nifty is above 7586, or below 6614. Possible? Well we don’t know. But frankly do you think the straddle buyer waits till expiry? No. Why?

Its because this is a quick profit or loss strategy. What happens if traders are happy with the election results and Nifty opens a huge gap up of 200-300 points? If the volatility has not dropped much, the straddle buyer will be making some profit. If they are, they will actually exit. Take their profits and run. No one waits till expiry hoping and praying Nifty ends above 7586 or below 6614. That is too much risk to take. With more than 24k at stake a clever straddle buyer knows that there is little margin for error.

Lets assume for the next two days Nifty actually trades above 7586 and the straddle buyer does not book his profits because he is waiting till expiry. In between some bad news comes in and if Nifty again goes back to 7100, you know what since the event is now over, there is a high chance that the volatility would have also dropped. There is no way in that case the straddle buyer will be making a profit. In fact if Nifty opens gap up 200 points and volatility also drops huge, then also the trader will be in a loss. Because both the premium of calls and puts would have erased significantly.

I hope it is now clear that volatility has a big role to play in this trade.

Small note: It is only 14 days left for expiry. I have not seen such high premium for ATM calls and puts in my entire trading career. During normal days, these options may be lingering around 90-100 odd points. Which means if volatility drops huge tomorrow, these options may fall near that price. A straddle buyer has to fight not just speed of the direction, but also volatility. Therefore straddle buyers usually lose money, and occasionally make huge amount of money. I remember a few months back Infosys was do declare their results. On the day of the results the stock fell as much as 15%. You know what, even then I calculated and saw that the ATM straddle buyers lost money. A drop of 15% can be nullified by a crushed volatility.

So when to play long straddle?

You need to look for times when some news event is going to be announced and the volatility is still low. This is a rare situation but it is possible.

Example?

For example if some news is expected in ICICI Bank, it is quite obvious that the volatility will be high for ICICI Bank. But if I am not wrong ICICI Bank has a big role to play in the movement of Bank Nifty. You got the idea. You can then play long straddle for Bank Nifty. Bank Nifty volatility will be low, so you will pay less money to buy a straddle. Now if you are lucky and ICICI Bank moves really fast in any direction, chances are that Bank Nifty will also move in the same direction pretty fast and all other banking sectors will also move in the same direction. Most of the times the stocks of the same sector move in same direction. Chances are that you will make money.

Another great way to play a straddle is to wait till volatility is crushed and direction is clear. Yes you can play the straddle even after the results are declared. But frankly why should you buy a straddle when the path of the stock is clear. In that case you ca buy naked calls or puts or even do a credit spreads.

When to exit the straddle?

You should keep a target profit and loss in mind. It will be foolish to wait till expiry really. Because you don’t know will happen during the expiry. If you have met your target profit, sell the straddle and take your profits. If your stop loss is hit, still exit – do not hope that the expiry will be in your favor. You may lose entire premium. Some people wait for two or three trading sessions. At the end of it they know the rally is over. Whether they are making a profit or loss they exit.

Can the straddle be hedged?

Anything can be done. Its your money and it is your right to save it as much as possible. Though what I am telling now will be technically NOT a straddle. But after-all you should always hedge your trades for the long term growth of your trading career.

How to hedge a straddle?

Its simple. Just sell a higher strike call (OTM Call) and a lower strike put (OTM Put). Now your buying cost of straddle is reduced significantly. By lowering risk you can even wait longer for profits if you don’t get it within a day or two.

By doing the above you will actually buy a debit credit spread and a debit put spread and not a long straddle. But who cares, its important that you make money. The strategy itself is not that important.

Have you ever played a straddle? Was it profitable? Did you hedge it?

Note: Protective put is also known as married put. Last year I had written an article on married put, but I think it was not well explained. So I am writing it again in details with more explanation and examples.

How many times has it happened that you bought a stock and it moved up, remained there for some time and then came crashing down before you could even book profits. You were not in a mood to book profits, thinking that the rally isn’t over. But exactly opposite happened. Sorry if it has happened to you. But the fact is you should have booked profits or bought a protective put.

What is a protective put?

If you buy a stock/future and the stock rallies, you are making a good profit. But this profit is just on paper as you got to sell the stock to book profits. However you are certain that the rally isn’t over yet and you do not want to sell the stock. In that case what can you do? If you sell the stock, any further rally has no meaning for you as you are out of the trade. You booked your profits and you are out.

In such a situation where you want to participate in further rally and make sure the profits made so far are not lost, you can buy an ATM (at the money) put. Now your profits are locked. How?

Example:

Lets suppose you bought ICICI bank stock when it was at 1000. The stock rallied and reached 1100. You are sitting at 10% profits. But its election time and you are sure the stock may rally 10-15% more. But anything can happen in the stock markets. To make sure you do not lose what you have already made, you but an ATM put. Since the stock is rallying, the puts will not be costly. Why? Because market players will pay more to buy calls as the stock is moving north. Who will pay more for puts when everyone knows that the stock is moving up?

Please note that if volatility is high, both the calls and the puts will be costly irrespective of the direction of the stock. This is done deliberately by the market makers to make sure there are no arbitrage opportunities. Can’t explain this in details. But just in short – if the puts were very cheap compared to calls – market arbitragers will buy both the calls and puts and make money if the stock moves in any direction fast. So why is this a problem for the markets? All professional traders will become arbitragers. The sellers will lose for certain. Markets should be a place giving equal opportunities to everyone. Arbitrage opportunities are not good. If every time arbitragers win, you and I will leave trading or join the arbitrage group. If there is no other group, there will be no trading.

If you now buy a ATM put, your profits are protected. However nothing comes for free. To play the up-move that may or may not happen, you got to pay a price. This price is the price you pay for the puts. Depending on volatility the price of ATM put of the current month may be 3-4% of the profits you are making. So it could be 30-40 odd points. Remember your profits are 100 points. Therefore if you think there is a 10% move still left and you want to play for that move, you have to pay 3-4% of what you have already made to protect your profits.

Now if the stock moves up, you will make money from the long shares/futures, but you will lose money in the put you bought.

If ICICI bank actually moves up 10% more to 1210, you can book your profits. Your profits will be the profits minus the price you paid to buy the puts. Remember if the stock goes up and finishes above the put strike price, the put will expire worthless. You will get nothing when you sell the put.

Of course if you think the rally is still not over, you may have to buy the next month’s ATM put. This depends on your view of the stock. However there is a saying in English – don’t push your luck. For traders its advisable that you book your profits and look for opportunities elsewhere. A 20% fast move is rare. Book your profits, don’t be greedy.

Still you can keep doing this till the rally is over. The only problem is that your profits will be reduced by the money you paid to buy the puts.

However there will be time when the stock will not move any further and slide down. The protective put will now do its job. How?

Lets take an example.

Step 1) You bought a stock at 1000.

Step 2) The stock rallies to 1100. You are confident the stock will move up even more.

Step 3) You buy a protective at the money (ATM) put at strike of 1100 by paying for 30 points.

Step 4) You were wrong. There was bad news in the company and the stock starts to come down. You are least bothered because you have bought the protective put.

Step 5) By the end of the month the stock reaches 900. 10% lower than your buy price.

Step 6) You close both the positions. You are in profits.

Calculations:

Loss in the stock 900 – 1000 = -100 * 250 = -25000.

Profit in the protective put: The 1100 put will be at 200 (1100 – 900).
The profits = (200 – 30) * 250 = 42500.

Total profits = 42500 – 25000 = 17,500.

In fact your profits are protected wherever the stock closes. Anywhere below the strike price of the put, you will make a profit of 17,500.

Now this isn’t over yet. What happens if the stock keeps rallying?

What happens if the stocks moves up and you want to book the profits at 1200? You will make even more money.

How?

Calculations:

Profit from the stock 1200 – 1000 = 200 * 250 = 50,000

Loss from the put: The put expires worthless. The cost of the put = 30 * 250 = 7500

Total profits: 50000 – 7500 = 42,500.

You will make more if the stock keeps rallying.

Isn’t the protective put a great option? Yes it is. It protected your profits and it also allows you to play the rally without worrying about the stock going down.

Important point: You know what the professionals do? They buy the protective put as soon as they buy the stock. Yes they are willing to pay a price to make sure they are not stuck at a stock if there is a huge decline. Overnight the stock may open in a huge gap down. In that case the put will make money and they can get out of the stock at a small loss.

Therefore hedging is important whenever you trade.

But remember protective put comes at a cost. So if you are long term investor and want to hold the stock for a long time, the protective put is not required. Since you are holding the stock and willing to wait to reach your target price – buying a put will be of no help. When trading everything has a purpose and we trade with a logic.

Buying a protective put for long term traders has no logic and does not solve any purpose. Yes suddenly one day if the stock jumps and you want to protect your profits – a protective put will be of help.

But if trading a stock for the short term (not intraday) – a protective put is a great trade to protect your profits.

Why not intraday? Because traders playing intraday have a stop loss in the system already and if the stock reaches that point the stop-loss gets violated and trade stops. What does a protective put do here? Nothing.

For intraday trading the best hedge is to sell calls if buying, and sell puts if selling the stock. Protective put will be of little help here as the Intraday traders book profits or losses in small movement of the stock. Protective put is meant to protect your money if the stock moves down substantially.

For positional positions short-term, if you have bought a future or equivalent value of stock, a protective put will be of great help if the stock declines.

Smart traders will actually put a stop loss to the put if they see there is no chance the stock will reverse direction if it is moving north. That way they reduce their losses from the put. But this can be risky.

I usually do not get out of the put until I get out of the stock itself. I therefore do not recommend a stop loss in the puts. Sell put when you sell the stock. I am a conservative trader and I love to remain that way.

Some people might think why a trader does not lose money if they buy the put and the stock rallies. That is because the put does not shrink in value the way the stock increases in value.

Put will not reach a worthless figure before the last trading day (probably hour). It will retain some value until the last hour of the last trading session of the month even if the stock has rallied a lot.

I hope its clear what’s the actual job of a protective put. Its strange how most traders in India feel its a waste of money to buy protective puts, until one day they see their stock crashing.

Have you ever bought a protective put? If yes, has it helped?

How many times it has happened that you bought a share and it started to fall? If you plan to hold it for sometime than it is OK not to worry and keep adding more of it if you think the stock will eventually go up in a few days.

But what if you have bought it from a trading perspective? What if you do not want to hold the stock for long? What if you bought a future of a stock and the stock starts to fall? You start to lose money immediately. The future will expire in a few days and there is no way to know if in that time frame your trade will be profitable.

This stock loss repair strategy will help to bring the stocks price down, and not eliminate the losses. If you can bring the stock value down – you are averaging its cost and if it goes back to its original buy value – you can make a profit. Some of the time it will happen, some of the time it won’t. Therefore the risk is yours.

However I recommend that you read this strategy and understand how it works. If you do not understand anything or want to share something with other visitors of this blog, please share your thoughts in the comments section below.

Lets discuss the strategy.

When do you implement the stock repair strategy? When the stock you bought has fallen to an extend where you are not comfortable holding it.

Now there are two things you can do to stop your losses:

1) Sell the stock and restrict your losses, or
2) Buy a put, or
2) Implement the Stock Loss Repair Strategy.

Here we discuss how to implement the stock loss repair strategy:

Lets suppose you bought Nifty Future at 6000 hoping that Nifty will go up. But Nifty started to fall. It has reached 5800. Right now your losses are 6000-5800 = 200 * 50 = Rs. 10,000.00.

You are uncomfortable holding the trade but somehow you feel that Nifty will go up. You can then implement the stock repair strategy.

What do you do?

You buy one ATM (at the money) call option, and sell two OTM (out of the money) call options. You just implemented the stock loss repair strategy.

Lets see the outcome:

Suppose the value of the 5800 ATM call option is: 120

And the value of the 5900 OTM call option is: 90

Your account will be credited with:

90*50*2 = 9000
120*50 = 6000
9000 – 6000 = 3000.00

Note: By implementing this strategy please do not think that all losses are eliminated. The downfall risk is still there. Which means that if the stock continues to fall, you will lose money. However by implementing this strategy you have reduced the cost price of buying the stock/future. And by reducing the cost price you have given yourself more chances of making money.

How does the cost of the stock gets reduced:

You see your account got credited by 3000. Which means right now you are only losing 10000-3000 = 7000. This means effectively you have brought down the buy price of your Nifty future by 60 points. How? 3000/50 = 60. It also means you have now a long Nifty future bought at 5940 and not 6000. If by expiry Nifty does not move anywhere you will lose only 7000 (plus commissions) and not 10000.00. Well you may recover your money if by the end of expiry Nifty reaches 5940. In fact if Nifty expires above 5900 you will end up making a good profit. Remember that 6000 was your initial buying cost, and because of this strategy you can make a profit even at 5900. But there is a twist. We will see what it is.

But before that an Important Note: Please do not get excited. This is not a golden strategy. Please do not repair an already repaired stock. What I mean is that if your stock keeps falling even after repairing, you got to take a stop loss. If you think you can buy another call and sell two more calls to reduce your buying cost even further – then you are doing a trading blunder. If you do so you will be naked one call sold. (4 calls sold, 2 calls bought and one long stock). If your stock does not reverse, you are fine. But if it reverses (more often than not it happens), you will be at unlimited loss in the naked sold call. So please do not over trade. Just exit if the position if its not comfortable to hold. And that is the best adjustment you will do.

Profit and Loss Calculations:

The downside risk is still there. That is if Nifty keeps falling even after the stock loss repair strategy is implemented, you should consider quitting the trade. No point in calculating the losses as the stock can go to zero. Just keep in mind that you should have a Max loss in mind. If that is hit, just take the stop loss. You are still better than people who did not do the stock repair strategy. Your losses were reduced by Rs. 3000.00.

Now lets see what happens if the stock reverses the direction.

Stock bought at 6000. Stock repair strategy done at 5800. If Nifty expires here, others with the same strategy lose Rs. 10,000.00, you lost only Rs. 7000.00 as you gained 60 points overall due to the strategy. 3000 saved.

Nifty now reverses.

Expires at 5900:

Loss from the future bought: 6000-5900 = 100 * 50 = -5000.00
Loss from the call bought: 120 – 100 = 20*50 = -1000.00 (at 5900 the 5800 call will be 100)
Profit from the sold calls: 90*50*2 = +9000 (both calls expire worthless)

Total Profit: 9000-5000-1000 = 3000.00

Note: Had you not implemented the strategy, you would have lost 5000 if Nifty expired at 5900. But here you make a profit.

Nifty Expires at 6000:

Profit from the futures bought: 6000-6000 = 0*50 = 0
Profit from the call bought: 200-120 = 80*50 = +4000 (at 6000, 5800 call will be 200)
Loss from the calls sold: 100-90 = 10*50*2 = -1000 (at 6000, 5900 calls will be at 100. They were sold at 90, so the difference is 10.)

Total Profit: 0+4000-1000 = 3000.00

Note: Had you not implemented the strategy, you would have made no profit and no loss if Nifty expired at 6000. (Actually you would have made a small loss because of the commissions involved in so many transactions. Do not ignore the commissions.) But here you make a profit.

Nifty Expires at 6100:

Profit from the futures bought: 6100-6000 = 100*50 = +5000.00
Profit from the call bought: 300-120 = 180*50 = +9000.00 (at 6100, 5800 calls will be at 300.)
Loss from the calls sold: 200-90 = 110*50*2 = -11000.00 (at 6100, 5900 calls will be at 200. They were sold at 90, so the difference is 110.)

Total Profit: 5000+9000-11000 = 3000.00

Note: Had you not implemented the strategy, you would have made 5000 if Nifty expired at 6100. But here you make less profit. And that is the cost you pay because you got nervous and implemented the stock loss repair strategy.

Needless to say you will not make any more profit than Rs. 3000.00 anything above 5900. The two sold calls will eat all the profits and you will have a limited profit of 3000.00.

That is the trade off. If you are happy with that limited profit, you should implement the strategy or wait for the stock to reverse. We all know hoping that the stock will take the direction of your trade is a useless hope. It seldom works if ever.

Stock repair strategy is great if you are losing money on a stock and feel that it may reverse soon but not much. If it does, good for you. Else you should exit if it hits a point where you feel uncomfortable. Feel lucky that you still lost less just because you implemented the strategy.

So, have you ever implemented the stock loss repair strategy. What was the result?

Diagonal call spread is traded when you are slightly bullish but think that markets will remain within a range for the next 25-30 days. In simple terms when you think Nifty will rise but not more than 200 odd points during the month and stay there.

So you must be thinking, why not trade call credit spreads which will also produces profits. Well if done right, Diagonal Spreads can make more money than credit spreads. We will know how.

Note: Since they can make more than credit spreads, its quite obvious that these are also complex strategies and may not be suitable for a less experienced trader. Moreover it is more risky than credit spreads. I recommend that you first try credit spreads and then try your hand at diagonal spreads. Don’t think about the profits, think about the risks first while trading and you will be a good trader.

How to create a diagonal trade?

Note that I am discussing here the diagonal call spread only as an example. You can also play the diagonal put spread. Diagonal Put Spreads are same except you sell a near month put and buy a far month put for protection of different strike. Everything else remains the same.

I hope you know about credit spread trade. The diagonal trade is somewhat same except the insurance you buy will be of different month (not of the same month).

For example you can sell one call option of the current month. This option lets say expire in about 30 days. Now what will you do if you were to create a credit spread? You would buy a call option of a higher strike price than the option sold to make it a credit spread. However in diagonal spread, you would not buy the option of a higher strike of the same month, but that of the next month. This option should expire after the option that is sold. It could be next month or next to next month. It depends on your view. However to keep things simple most traders sell option of the current month and buy option for protection of the next month. This completes a diagonal spread.

Example:

Lets say Nifty is at 6500 and you think that in the next 30 days it will reach 6700 and stay there for some time.

To trade a diagonal call spread you would:

1. Sell a current month call option strike 6700.
2. Buy next month call option strike 6900 or any other OTM strike. I will explain a bit more about this a little later.

Selling the near month option will give you cash. But since you are buying next months option – your account will be debited. Depending on the value of the options sold and bought there will be a credit or a debit to your account.

If the option you sold had more points that the options bought – your account will be credited.

If the option you sold had less points that the options bought – your account will be debited.

The ideal situation is – If you can get a credit to trade diagonal trade. Then we will learn how you can ride the markets for free. Therefore most professional traders prefer a credit while trading diagonal trade.

What happens once you have bought a diagonal spread?

So you have done the diagonal trade and your are exited because you got money while doing the trade?

Well things are not that simple. Here is what can happen when diagonal trade has been done and current month expiry nears:

Scenario 1: The sold option may expire worthless, volatility has increased and the index is near but below the short option:

This is a great situation. You keep the premium received from the sold option and because the volatility has increased you can also sell the bought option for less loss or even a profit. So essentially you made money from both the option sold and the option bought. Remember this a very rare occurrence though. If it happens consider yourself lucky. Your ROI will be significant. I cannot calculate as its very difficult to predict the next months option price. But one thing is for sure, if this happens you make more than you could have from selling a credit spread.

Note: If expiry is near and you see you are making profits in both the options, you should immediately buy back the diagonal spread. Everyday is a different day in option trading and you never know if you will actually make such a good profit next day or on the day of expiry. You are making good money so you should exit. Don’t be cheap, do not wait for expiry to eat the full premium. You may end up in a loss.

Scenario 2: Same as Scenario 1 except the volatility has decreased.

This too is a good result. Since you have a credit, if the short option expires worthless there is no way you can lose money. But your profits depends on the value of the bought option. Because the volatility has decreased you may not get good cash back by selling it. However you have made a profit. But you could have made more had you done a credit spread. Still the ROI should be great.

Now I had said earlier that I will explain a bit more about the bought option later. Remember you had a credit when you traded the diagonal spread? If you are not getting good money back by selling the bought option and your view is that the markets will keep going in the direction of the bought option i.e…. going up if a call, and going down if put, you can actually ride the markets for free. Why? Because you were already paid for the bought option by the option you sold. If you are right you can make unlimited profits from the option bought for “free”. What else can you ask for?

If you ask me, I don’t take a risk. I sell it and look for another opportunity. But for aggressive investors, this may be a suitable strategy. You bought the call for free, so why not try to take advantage? Even if you sell it at cost to cost – with no profits, your ROI will be great.

Scenario 3: Short is breached, index going against the short call, but the long call making profits:

If volatility has increased, there are chances that the value of the diagonal spread has increased too. Frankly in this situation there is no perfect answer, except if it far exceeds the short, the spread will be in loss. Why? Because the short being in the money will start losing value faster than the long call gaining in value. The long call is for next month and is still OTM. The further the indices move away from the short strike, the more the loses. But if it has not moved too far, and the vega has increased, there are chances that the diagonal spread will make money.

Ideally in this situation you should exit even if making a small profit. If it goes too far, I bet you will lose money.

Scenario 4: Index/Stock heading lower:

4a) If volatility has increased: In that case if its still not gone very low than the short strike, it may be that you are getting good value by selling the long and buying back the short. Profits for sure.

4b) If volatility has decreased: It depends. But the profits will be little as the short may have lost most of its value, but the long also may have lost a substantial premium. Therefore you may not make good profits. If done for credit you should make a profit.

In both 4a and 4b, if the indices has gone too far from the short strike and if the diagonal spread was done for debit, then the spread may be in huge loss especially if volatility has decreased.

Some Important points to note:

1. Diagonal spread is a complex trade. It is not as easy as it seems because apart from the movement of the stock, it is also a vega (volatility) play. If the trader is wrong anywhere – he will lose money.

2. Profit comes but you will never know when to take it as greed will take over and you will feel more profits may come. You may be surprised to see next day if volatility crushes and your position is in a loss.

3. Diagonal spreads will produce great profits if the stock stays just below or above the short strike for a long period with volatility increasing. Well this happens often, but how on earth do you time this situation?

Therefore if you are beginning to trade in options its highly recommended that you start with credit spreads or collar strategy and move on to other strategies. You may in fact feel no need to trade any other strategy in your life time.

Important Note: I will discuss Covered Combination in this article, but as a bonus I will disclose a tip that will help you to limit unlimited losses in case the strategy goes wrong. Remember as we will discuss, covered combination strategy can incur double unlimited losses if the trader is very unlucky. But otherwise, and most of the times it is a great strategy. So please read the full post to understand how to limit your losses in this strategy.

How many times it has happened that the stocks in your portfolio do not move much in a month? It happens in most months isn’t it? Only in one or two months in a year either it rises by 10-20% or more or declines by 10-20% or more. Otherwise it stays in a range. The question is how to make money in those months when the stock does not move much and is range bound?

Covered Combination is the answer.

Note: Covered Combination should be done only if you own equal to or slightly more or less than the stock’s equivalent value in a lot in its futures. For example if you are doing it in ICICI Bank (my favorite stock :)), you should own at least 250 shares of ICICI Bank as one lot of futures of ICICI Bank is 250, Or it can be done with futures. But technically speaking Covered Combination is done with shares in your account.

Now lets jump straight to the strategy. The Covered Combination strategy:

It is a mildly bullish to neutral strategy. When you own a lot of shares of a company and its not moving much, you can adopt this strategy to make money while still owing the shares. However if the stock tumbles heavily, you lose money more money than you could have by not entering this strategy. If your stock does not move much, you stand to make a good amount of money than those who did nothing.

The good news is that most of the times the stocks do not move much, but the very bad news is if it falls badly you tend to lose a lot. Another drawback is you make less but do make money if stock continue to rise. So the only drawback of this strategy is if the stock keeps declining.

Lets take an example:

You have 250 shares of ICICI Bank bought at an average value of Rs. 1,000.00 per share and you think for the next one month the stock is not going to move much because the quarterly P/L announcements have been made and the results were as expected by the market. There isn’t much news to follow in this stock so for the next one month or so the stock may move in a range.

On 19-Feb-2014 ICICI Bank stock closed at 1030.90 (NSE Rate). Your view is that till the F&O expiry of March 2014, the stock will not cross 1100 and will not fall below 950. You can trade a Covered Combination for this stock.

You can then sell the OTM 1100 ICICI Bank 27-March-2014 Call. Closing price is: 14.35.

Similarly you can sell the OTM 950 ICICI Bank 27-March-2014 Put. Closing price is: 9.00.

Your account on the next trading day will be credit with:

((14.35 * 250) + (9 * 250)) = Rs. 5837.50 (less brokerage commissions).

If you view is correct and on 27-March-2014, the March expiry day, ICICI Bank trades somewhere between 1100 and 950, you pocket the premium received when you sold the call and the put. Rinse and repeat every month – keep making money, month after month until ICICI Bank breaks the range. You can then look for another stock.

Please note that you were planning to do nothing with the shares anyway and just hold them, so you just made this cash for free. Moreover most brokers will not ask for additional cash to sell the options, the stock you hold in your demat account will act as collateral. You sell the call and the put against your shares as collateral. Please check with your broker, my broker allows it.

Warning: If ICICI bank goes WELL below 950, your broker may give you a warning call to either close the position in the PUT or sell the shares.

Well the fact is you need not bother till the break even point is reached. How do you know the break even point?

14.35 + 9 = 23.35. 950 – 23.35 = 926.65 is your break even point for the put side. We need not calculate the break even point for the call side as the shares will make a profit anyway. If ICICI bank falls further than 926.65, you will incur losses in both the shares and the sold put. A bad situation to be in.

Therefore Covered Combination is a limited profit but unlimited loss strategy.

Another Important Note: You may get aggressive and sell 2 lots of calls and puts thinking that you get double the money so your break even point is even further down. DO NOT EVER do this. Your break even point will not change even if you sell 100 lots. You will be in big trouble if the stock keeps moving south. And you know very well that does happen often.

Trading more than your account size is never recommended. Agreed you may be right in most occasions, but one overnight fall in ICICI Bank will wipe out years of profit and some more and you will be left in a heavy loss. Selling naked options is a dangerous trade and should be done with caution and experience. One lot is fine, because I will tell you a tip that will reduce your income but help you to limit the losses as well.

Again do not sell 2 lots of options of either calls or puts if you have only 1 lot of future or cash invested in the stock. Of course if you have 500 shares of ICICI Bank, you should sell 2 lots of calls and puts.

Now the tip on limiting losses:

Covered Combination as you know by now is an unlimited loss trading strategy. But and this is important, the loss is only when the stock keeps declining in value. If it declines a little and/or goes up a little, you are safe as the call and put both options will also decline in value with time and will expire worthless. You make money from both of them.

If the stock keeps moving up, there isn’t any problem. The put will expire worthless and you can keep the premium. The call will increase in value, but so will your shares.

Lets suppose ICICI Bank on the March expiry day is trading at 1200. The put expires worthless. But the 1100 call will be trading at 100.

Your loss in the call: 14.35 – 100 = -85.65 * 250 = -21,412.50
Your profit from the put: 9 * 250 = 2,250.00

Total loss: 2,250 – 21,412.50 = -19,162.50

Now your profit from the shares: 1200 – 1000 = 200 * 250 = RS. 50,000.00

Total profit: 50,000.00 -19162.50 = Rs. 30,837.50

Agreed had you done nothing and kept the shares, your profit would have been 50,000.00. Now you profits are less, still significant. But think frankly, why would someone wait for so long to sell ICICI Bank shares? How on earth they know that ICICI Bank will go up to 1200 by the end of March?

You waited because you had a reason to wait. You knew that your profits are limited so why sell when only a few days are left for expiry? Ultimately the result was satisfactory. You made a big profit and were already making profit using this strategy. You should be happy with the limited profits. Overall your stocks fared better than people who did nothing with their stocks.

When ICICI Bank was rising, most people would have already sold their shares when it was at 1100 – taking a profit of 10% or Rs. 25,000.00. You are still better than them.

Moreover add to this the premium you collected every month, month after month. Even if for 5 months if ICICI Bank was trading in a range, you would have made 5837.50 * 5 = Rs. 29,187.50 EXTRA if you did a Covered Combination month after month. (This depends on the option prices prevailing at that time. It can be more or less.) Your friends who did nothing with their shares of course made nothing.

29,187.50 + 30,837.50 = Rs. 60,025.00 profit on 1000 * 250 = Rs. 250,000.00

That’s an absolute return of 24.01% ((60,025/ 250,000) * 100) in just 5 months. What else can you ask for?

So what can be wrong? Why people don’t trade Covered Combination and make money on their idle stocks lying in their demat account?

There are two reasons:

1. People think options are too risky and do not trade out of fear, or they just don’t know this strategy exists.
2. The risk is unlimited if the stock plunges.

No 2 is a huge problem. A big decline can take away months of profits and you will really feel bad about your decision for trading Covered Combination. What if this happens in your first month of trading Covered Combination? However there is a trick to limit losses to some extend in this strategy.

What if you make selling the put into a credit spread? You sell one lot of 950 put and buy another lower put for protection.

Since our problem is the put and not the call, we will only buy a put for protection and leave the call naked so that we still get a reasonable premium month after month and still will be able to limit losses to some extend if the stock keeps going down.

Lets see if that is possible.

The 900 March put is currently available for 4. Which means if you buy it you will be protected for losses beyond 900.

You will still get a credit. Sell 950 at 9 and buy 900 at 4. Your total credit is 9-4 = 5.

You still get 5 * 250 = 1250 from the put. If ICICI Bank does not fall below 950 you can keep that premium. But yes if it falls below 945 you will have to take a loss in the put. However since you got 14 from selling the call you are safe till 945 – 14 = 931.

So what’s your Max loss here? 931-900 = 31*250 = Rs. 7750. Below 900, the 900 put will protect your losses. That’s the Max loss you will suffer for trading Covered Combination. Remember this will come ones or twice in a year. In other months you will keep making money from Covered Combination.

Isn’t this an excellent strategy to make money from stocks lying idle in your account?

Disclaimer: Examples given here are should not be substituted for real life trading. These are just examples to help you understand this strategy. When you trade Covered Combination, you might find better option prices or worse. This article does not guarantee that you will make this kind of a return. But such returns are possible, if you look for non-volatile stocks. The only trade off is that non-volatile stocks have low premium in their options.

Will you try Covered Combination now? I will be glad if you do. If yes please write your results. It will be great to share.