Conviction is what drives the trading in any asset class that does not have predefined cash flows. We tend to bet big when our conviction (belief in the expected outcome) is higher. Indeed, conviction defines our aggression. I will buy 10 lots if I am super confident and two lots if I am moderately confident.
However, the money to be deployed in the market is always limited compared to the ideas presented by the market. Finding a mechanism to manage this aggression is necessary so that we do not go all-in when our conviction / aggression is high.
Options trading can help here.
Let us make a few assumptions before we get into the ways to manage aggression. Assume that the time given for the trade to materialise is 1-2 trading days. Time is always the spoiler when it comes to straight Options trading, with single Options like buy Call or buy Put. Secondly, we all know that if we are bullish we would buy a Call and if bearish we will buy Puts.
Indices like the Nifty, Bank Nifty, FinNifty will always have liquidity assuming that trades are in stocks and indices with liquid Options that are available for trading.
The first measure of sensitivity we need to understand is delta. Delta is an Option Greek that’s easily available on most Option chain analytics apps. Delta is nothing but sensitivity of the Option to the underlying stock or index. It is the estimate of how much an Option’s premium may change given a Re 1 move up / down in the underlying security.
Example:
50 delta Option means, if the stock moves by Re 1, the Option’s premium will move by Re 0.5.
Delta will always be between 0 to +/-100 or 0 to +/-1. Some may put 50 delta as 0.5 delta as well. Both mean the same. Also, Put delta is negative and Call delta is positive, because Puts rise with fall in the underlying stock price.
Beware of 3 things
1. Higher the absolute delta (ignoring the sign +/ -), higher will be the movement in the premium.
2. Higher the absolute delta, higher will be the profit (if all goes well).
3. The premiums for higher strike Calls and lower strike Puts (compared to the current price) rise faster with favourable movement in the underlying stock’s price.
Last point is a little tricky, but the example will help explain.
If Nifty @17,900 rises to 18,000
50 delta Call of 17,900 strike @102 will be 166 = rise of 64 = rise of 63 percent.
35 delta Call of 18,000 strike @ 62 will be 110 = rise of 48 = rise of 77 percent.
So remember, the fight will always be between absolute profit vs. return on investment (Rs 64 vs. 77 percent). Considering the above, there are three ways we can manage our aggression.
1. The best balance for moderate aggression I could find was in the strike with 50 Call delta (-50 for Puts), which is generally the strike closest to the current market price (CMP).
2. If you are a little less aggressive, look at 40 delta for Calls (-40 delta for Puts). This will deliver in lower profits + slightly better returns + cheaper Options with lower absolute loss (at the cost of lower absolute profit).
3. If you are super aggressive, resort to 2 X 30 delta Options for the following reasons:
a. 2 X 30 delta Options will be cheaper than 1X 60 delta Option. Sensitivity is taken care of.
b. You can win in both ROI and absolute profits.
So why not do all trades like that? Well, it could be equally punishing if things go wrong (stop loss). Also, this trade requires fast and favourable movement (which is the expectation of the super aggressive).
This is the way one can easily manage aggression in trading without changing the capital allocation a lot.
Just one caveat, time-value related reduction in premium is very high during the last few days of expiry. Hence, for the last two days of expiry stick to at least 50 delta Call or -50 delta Put.
a. 2 X 30 Delta options will be cheaper than 1X 60 Delta Option. Sensitivity is taken care of.
b. You can win in both ROI and Absolute Profits
So, why not do all the trades like that? Well, it could be equally punishing if things go wrong (Stop Loss). Also, this trade requires fast & favorable move (which is the expectation of super aggressive).
This is the way one can easily define aggression in the trading without changing the capital allocation a lot.
Just one caveat, since time value related reduction in premium is very high during the last few days of expiry. For last 2 days of expiry at least stick to 50 Delta Call or -50 Delta Put.
Disclaimer: The views and investment tips expressed by experts on Moneycontrol are their own and not those of the website or its management. Moneycontrol advises users to check with certified experts before taking any investment decisions.