We’re now at the point where the option strangle we took on Friday has worked out in our favour. While the Banknifty has moved back to nearly the same point at which we started our trend trade on Thursday.
Our primary entry was a short BankNifty call at 11200, assuming the stock will complete the downtrend and walk towards the lower Bollinger.
On Friday, this was achieved, and the call we had written at 170 was at 96, giving us a Rs. 74 profit. However, we decided to convert this into a strangle trade, with a put written at 10,900 (lower end support) which gave us a long payoff and we targeted eating up of time value which would decay over the weekend. (The risk was a large overnight move).
We now had a short call at 11,200 at 170, and a short put at 10,900 at Rs. 138. The total premium received was Rs. 308, which is about Rs. 7,700 for a lot of 25 BankNifty. We allocated Rs. 100,000 to the trade.
On Monday the Banknifty recovered somewhat and the stock closed squarely within our range. At Capital Mind, we did nothing, because the time premium was still decaying in our favour. Both the call and put closed at Rs. 100 on Monday, for a total price of Rs. 200. This is already profitable by Rs. 108.
Today, the Bank Nifty opened up and continued its journey upwards. The MACD cross late yesterday was an indicator to finally exit the trend, but we weren’t in a trend trade anymore – we were in a strangle trade.
It’s now time to exit, and we have exited at Rs. 117.5 for the call and Rs. 77.8 on the put, giving us a profit of Rs. 2,817 on the trade.
Note: I haven’t accounted for brokerage and other costs. These can be substantial – of the order of Rs. 200 for such a round trip trade.
Although the margin required was much lesser, we allocated the full Rs. 100,000 to trade as a “just in case”. You would have needed just Rs. 40,000 to be placed as margin for the trade. The remaining can stay in an interest yielding instrument. I haven’t accounted for this interest either. That might balance out the brokerage.
The return is 2.8% in about a week, and your capital is now free.
Taking bets on one security is a little scary, and it is better to diversify. But how much? Can you take a 100 trades? That would spread you too thin, and there might not be enough valuable opportunities at all. One is too less. What’s the ideal?
The answer, to a discretionary trader (versus an algorithmic one) is between two and ten. For an algorithm it doesn’t really matter, since a back-test can reveal how well your diversification strategy would have done. But what we are doing isn’t a mechanical trade. There is an element of discretion in it, and while some traders might say this is not the right way to trade, I think you should find the kind of trading your are suited for.
(Remember that even “mechanical” trades involve a layer of discretion in the parameters chosen on the system. I might do a mechanical “MACD Crossover” system but then I’ll choose the parameters for the MACD based on discretion)
We’ll get to mechanical systems at a later date. At this point, we have to attempt to find more opportunities and create a portfolio.
Let’s say we will keep a maximum of five positions. at an allocation of Rs. 200,000 per trade (maximum). A Banknifty trade would involve taking two lots (50 instead of 25) but a larger contract like Larsen and Toubro (Price: 1000, Lot Size: 500) might involve just one lot.
Obviously the next question is: where’s the next opportunity?
Currently we remain in “scout” mode, as nothing looks attractive enough. Optionalysis will return when we find something worthwhile. And that brings us to:
There is no reason to take a trade if there is no proper entry. Trading derivatives has both the risk of a move against you and the leverage you take. There’s no reason to take a trade if there is no trade. As you can see above, when an opportunity manifests itself, your returns will compensate you for the time lost. (In the trade, we made 2.8% in a five days. We’d love to make that much in a month!)
The idea of entering a trade has to be that you take a calculated risk. Not a gamble.
If there’s no trade, it’s best to stay in cash. Optionalysis will be back when there is a trade or a set of trades to take. And that could happen as soon as later today!
Nothing in this newsletter is financial advice and should not be construed as such. Please do not take trading decisions based solely on the matter above; if you do, it is entirely at your own risk without any liability to Capital Mind. This is educational or informational matter only, and is provided as an opinion.
Disclosure: The authors at Capital Mind have positions in the market and some of them may support or contradict the material given above, or may involve a direction derived from independent analysis.