OTM Option vertical spread – defined risk and stable profit

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What is happening in the markets?

Normally, after a large trend has passed, there is a period of pullback or just plain old consolidation.

What happening in market nowadays is that Nifty has cooled off from 18,400 in recent months.

However, the last few weeks have been unusual in that the Nifty has been moving in large fluctuations, attempting to recover and get back on track before giving up.

Consolidations, particularly choppy ones like the ones we’ve been seeing for the past three weeks, can produce misleading signals. Vertical spreads, on the other hand, could come in handy with Out of The Money (OTM) options.

On a daily basis, the movements have also been relatively large. However, if we look at the total change in the Nifty for December, it is nearly zero so far.

The difficulty of being stopped out in an unfavorable fluctuations is the most painful, especially when the trade ends up becoming a winner after being stopped out solely because of that temporary move.

Should we not keep Stop Loss to avoid this?

No, on the contrary, every trade in these types of uncertain times should have a well-defined loss strategy in place.

Answer lies in Vertical spreads

Vertical spreads are created by purchasing a call/put option and selling a higher call/lower put option against it.

The maximum profit in Vertical Spread is the difference between the strike purchased and strike sold less the net premium paid.

The maximum loss is equal to the net premium paid.

During consolidating times, especially choppy ones, stronger names would weaken while weaker names would strengthen but with less intensity.

What happens in fluctuations in Market?

All that is required is that when market forces push our trade into unfavorable territory, we have a mechanism in place to allow the trade to weather the storm and survive to reap the benefits of the favorable move when the tide turns

Out of the Money (OTM) Vertical Spreads can be useful in this situation.

What are OTM Vertical Spreads?

OTM Vertical Spreads are created by establishing a Buy position in the Spread in Higher Call/ Lower Put and a Sell position in Higher Call/ Lower Put.

In Out of the Money (OTM) vertical spreads, we initiate a Buy position in a Call or a Put that is slightly higher or lower than the current level, implying that a relatively higher Call/lower Put is purchased.

As a result, the spread is less expensive.

This aids in dealing with stop losses because, with a lower initiation cost and a higher maximum loss, this strategy becomes too cheap and can thus be kept as a no-stop-loss trade.

So, regardless of the volatility, we do not need to exit.

On the plus side, whenever the tides turn and the move approaches the sold option strike, the strategy typically pays out around 1-1.25 times the maximum loss.

This may not make the profitability very appealing, but it would certainly increase the courage to engage in such a trade.

How booking partial profits work?

Ideally, I would not advise anyone to take additional spreads in consolidation, but doubling these spreads has recently worked for me, with half of the quantity booked as soon as the spread doubles and the rest held at zero risk.

Nonetheless, I would leave position sizing to the trader’s conviction, but OTM Vertical spreads are worth noting as a tool to avoid being arbitrarily stopped out in volatile markets.