Do you have an appetite for risk?
As a section of market experts disapprove short-term views, spread trading comes handy for those who want to play shorter version of the game, writes Vyas Mohan.business Updated: May 14, 2007 00:57 IST
The equity market has of late been very volatile. While volatility keeps many investors out of the fence, it is the favourite hunting ground for those who have the nerves to take the roller coaster ride.
Though there is good money to be made through the highs and troughs of a volatile market, what turns off most investors is the high risk factor attached to it.
Risk or the probability of loss arises from a price movement opposite to the direction the investor expects. Which means, risk could be reduced considerably if the investor is prepared for a market movement in any direction.
By taking multidirectional positions in the market, an investor can cut down the risk factor. This can be done with the help of spreads, or a trading strategy that involves taking a position in two or more options of the same type.
“In a volatile market, like the current one, a combination of different positions is very good. When one trades on spreads, he/she buys and sells options. This way, even if the market does not go as expected, the risk of capital loss is reduced,” says Vijay Bhambwani of BSPLindia.com.
In other words, a spread is a combination of two or more positions in the same security, with more weightage on a position in the most-expected direction of the market.
Brokers advise their clients to use such strategies under volatile market conditions. “We recommend spread trading. By trading on spread, one effectively hedges his risks. The counter position taken acts as an insurance,” says Rahul Nangalia of Nangalia Stock Broking.
In effect, a spread creates a definite profit horizon, while limiting losses. Creation of spreads depends on the investor’s take on the market under existing market conditions. For example, imagine an investor who is bullish on a particular stock buys a call for Rs 3 with a strike price of Rs 30 and sells one for Re 1 with a strike price of Rs 35.
This creates a bull spread. The net cost of positions is Rs 2 (Rs 3–Re 1). Now, if the stock price dips below Rs 30, the maximum loss incurred to the investor is Rs 2 (the net cost of positions). On the upside, the investor achieves breakeven if the stock price touches Rs 32 (Rs 30+Rs 2 as the cost of position). Thus, any move over Rs 32 is profitable for the investor.
Had he only sold calls, the investor would have stood to lose if the stock price moved above Rs 35, as he had, by selling a call, given someone else the right to buy the stock at Rs 35.
But remember that the investor has done so only after procuring the right to buy the stock at Rs 30, by buying the call. So, while any move in the stock price above Rs 35 is profitable to the party who bought the call, the investor does not lose as he has the right to buy the stock at Rs 30 and the obligation is to sell it only at a higher price of Rs 35.
By this strategy, the investor creates a virtual profit zone (Rs 32 to Rs 35 in this case), wherein both the profit potential and risks are limited (risk of only Rs 2).
The bull has secured his ground. Now how does the bear do this? Buying a call with a higher strike price and selling a call with a lower strike price makes a bear spread.
Imagine an investor buys for Re 1 a call with a strike price of Rs 35 and sells for Rs 3 a call with a strike price of Rs 30, thus receiving Rs 2 upfront. Now, if the stock price drops below Rs 30, the investor walks away with the money received upfront.
Having received Rs 2 upfront, the Rs 30 call he has sold is tantamount to a strike price of Rs 32. Hence only a move in the range of Rs 32-35 could cause a loss of maximum Rs 3 to the investor.
Since the investor owns the right to buy the stock at Rs 35, any move above Rs 35 also limits the loss to the earlier arrived figure of Rs 3.
Bear spreads can also be created by buying a put with a high strike price and selling one with a low strike price. But that requires upfront payment.
Spreads can be brought into life in different ways. Some of the highly useful spreads trading strategies include butterfly spreads, diagonal spreads, calendar spreads and so on.
Further, combination spreads can be created by using puts and calls on the same security.
While a section of market experts disapprove short-term views on the market, spread trading comes handy for those who want to play the more exciting shorter version of the game.
After all when it comes to equities, there is not much one can do than make a few bets and sit tight. Let the scream machine run.
E-mail author: email@example.com