Last fortnight we legged into the call vertical spread component of a 3 month Nifty condor. Our rationale for entering the trade was as follows:
We see from the graph that the Nifty has had difficulty holding the 5400 area since mid-April. So our hypothesis of a break-down would be in trouble if the Nifty were to push back through 5400 with good volume. This is our “pain point”. We could thus look at a 3 month [5400-5500] sold call spread. This involves selling a 3 month 5400 strike Nifty call and buying a 3 month 5500 strike Nifty call. Note that our maximum risk is limited to 100 index points. The call spread brings in around 27 index points of credit, which gives us a best-case return of (27/(100-27))= 37% on capital risked.
So how has the first leg of the trade performed to date? See Fig 1 below.
Fig 1 Nifty downside breakout
The Nifty closed Friday 18/05 at 4891.45. Recall that the Nifty was trading in the 5100 region when we put on the trade. The anticipated breakout from the [5200-5500] range did occur and the trade moved decisively in our favour. Did we know that the market would move in our favour? Absolutely not. There’s no crystal ball here. We defined our maximum risk (the “pain point” above), calculated the risk-reward expectancy and put on the trade. We then let Mr Market do what he wanted.
Scaling
The 3 month call spread is now worth around 18 index points. This gives us an unrealized profit of (27-18) = 9 index points. This means that we’re up (9/(100-27)) = 12% on capital risked. This could be a good time to take some money off the table. For example, if you sold three spreads, you could buy one of them back and let the other two run. This is called “scaling” and is key to trade management. The idea is not to let the whole position run for the final target (i.e. 37%). Markets do pull-back and sometimes violently. It’s a drain on psychological capital to leave money on the table.
Key support / resistance areas are good areas to scale. For example, the market found balance in the 4800 area before starting the previous leg up, so that should logically be the first exit point. Remember however that this is not engineering – the market does not have to tag 4800 before attempting a bounce. Being excessively rigid in setting your exits could cost you financially and emotionally. Save yourself heartache and exit ahead of the key areas.
Downside targets
We said last fortnight that if the selloff is part of a short term move down, then the final target would be the 4600 area. That hypothesis still holds. Even with an increase in volatility, that would give us an exit at 5 points or better on the second lot. That would imply a return of (27-5)/(100-27) = 30% on capital risked. Given that 4600 is a fairly strong support, my plan would be to take the 2nd exit well ahead, say at 4700 and the final exit around 4600. At that point I would also be looking to enter the put spread leg of the condor. The put spread would involve selling the 4600 strike put and buying the 4500 strike put. The 4500 area represents the December 11 low which is also an intermediate term low. That would be the “pain point” of our put spread.
Staying with the trend
The dark art of spread trading is learning to align oneself with the trend. For the [4500-4600] put spread, I would put on a smaller size (than the call spread) and look to take profits more quickly. In fact, I would look to sell more call spreads on a first bounce but in smaller size or with tighter exits as we gauge buying interest at the 4600 area. Our first job as traders is to preserve capital and manage risk.
Notice: Trading options involves substantial risk of loss and is not suitable for all investors. You may lose all or more of your initial investment. Information shared here is for educational purposes only.
To be published in The Statesman 21/05/2012