Thursday, September 24, 2009

Using Options in Trend Following Systems

Aurobindo asks:

"How can we reduce the risk using options in a trend following system. As price reaches certain moving average we see a change in direction. But before this change there are few whipsaws. Can we effectively reduce the risk by using a combination of options and futures?

I googled a lot found few but nothing partticularly on trend-following-system + options.

Could you please share some strategies involving options in trend following system to reduce risk?"

My Notes: The use of options in trend following systems has many advantages:
(1) If the system enters a strong trend, then the option will make almost as much money as the underlying, since the option will achieve a delta of 1.
(2) If the trade is getting whipsawed, the options will lose a less money since the price decay in options will be less than the underlying.

I used the idea of using options as a substitute for the underlying, in an hourly trading system for the Nifty. When the system gives a buy signal, we buy calls which are one strike deep in the money. When the system gives a sell signal, we buy puts one strike deep (and sell any calls we were holding). Here are my observations:

(a) The impact of implied volatility on such a trading system was more than we imagined. When we are buying, the trend is moving up, with the call options priced higher. We are buying puts when the trend is moving down, thus puts are price higher. At that point, if we sell the calls, we will get a lower IV, and, much lower prices than when we bought them. Thus, the gains in periods of whipsaws were much less than we thought we will get.

(b) When we found a trend, the options lost I.V. quickly, as the strike prices moved deep in the money. So, we lost a lot of premium value which we had paid for.

In conclusion, the use of options was not a success. Now, this was an hourly trading system. Perhaps, an end of day system may have different results. But, then, the issues will be of shifting from one month to the other, which could face similar problems. It may be wise to paper trade a system with actual bid and ask spreads used to take the paper trades.

More on the Powergrid trade:
I identified the basic pattern for the trade. Entry was done using intra day charts, which sometimes allow us to get an early entry prior to a breakout.

The NIFTY
A small correction may have started. Today's late afternoon pullback, could be the result of the F&O expiry. Our cycle indicators suggest that prices should move down.

8 comments:

vaibhav said...

GOOD EVENING SIR -- I ve been regular reader of ur blog and subscriber of trand mechanic too --your comments about market are realy inspiring and helping me to improve my trading strategies - they r realy fantastic --regarding use of options -- what i ve realised is tha smartness lies in selling the options --e.g covered call write or ratio writing or selling strangles // straddles--as time factor is in your favoyur --e.g say sell nifty 1 lot @ 5000 --and sell out of money puts -say 4800PE 2 lots @ 80 -- u willl get some hedge if market goes against u -- if market rangebound --still minor profits -- if market goes in ur favour -- u can close the position--both legs - in handsome profits -- pls give ur valuable opinion -- whether such strategy should be employed all the time ---eg -- BULLISH VIEW -- BUY NIFTY 5000-- 100 QTY -- SELL 5200 CE 200 QTY @ 80 // BEARISH VIEW -- SELL NF 100 QTY @5000--and SELL4800 PE -- 200 QTY @ 80--awaiting SUDARSHANji s guidance -- with regards -- dr vaibhav

saket said...

hello sudarshan sir i have query regarding breakouts,sir is there a way to filter breakouts,what stops can one generally use.recently in the markets many stocks brkout daily so its been difficult to pick up stocks which to choose n which not.also the moves when breakout happen are big therefore the stops have to be deep.can u throw some light on this matter.Thank you

Shazia said...

Sir,
In todays blog you are of the view that a small correction may have started, but on tv you were reluctant to go short at the end of the day. I was short on the markets but i hurriedly covered after your comments.
Thanks
Shazia

NITIN DAMLE said...

Sir,
I think short term tone of mkt. is down we will see a correction up to atleast 4850. Can we go short with stop @ 5040 spot nifty? Pl. comment. I think it will be a low risk entry
Nitin Damle

VIKAS said...

HELLO SIR, I M ONE OF REGULAR READERS OF UR BLOG & UR FAN TOO.I HAVE ONE QUERY-I TRADE ON MOVING AVERAGE CROSSOVERS. ALTHOUGH MY ENTRY PT BECOMES GUD (in trending mkt),BUT MY EXIT PT (reverse cross) GIVES ME VERY PETTY PROFITS. IF I BOOK PROFITS AT SUM LEVEL(discretionary) THEN I GET OUT OF TRADE OR MISS THE MAIN TREND.PL SUGGEST ME SUM EXIT STRATEGY/INDICATOR TO LOCK PROFITS AT SUM HIGHER LEVEL & THAT INDICATOR SHUD MAKE ME RE-ENTER TO BE WITH THE MAIN TREND(first entry pt being crossvers only)...HOPE U WILL GIVE UR VALUABLE COMMENTS FOR THE BENEFIT OF ALL..

REGARDS,
VIKAS SHARMA

keralkrishna said...

gud morning sir
iam presently following trends based on DP and using a calculator (downloaded from the net) to find DPs.what is the best calculting method to find the DP? previously i was blankly following some tips and all to do trading. i started following trend following strategy after becoming a follower in your blog. thanks for the guidance.

amitkbaid1008 said...

Dear Sudarshan Sir,

I am a regular reader of your blog since only a few days. Today I observed your comments regarding your experience of using Options in a trend following system. You are rightly pointed that when we buy CALL/PUT we are paying more premium since the trend is up/down. My point is that why we should SELL IN THE MOENY PUT instead of BUYING CALL. In a strong trend PUT will lose money faster than CALL. But I see that even in case of strong trend profits will be limited to the premium received whereas losses can be unlimited if trend goes in opposite direction.

Seeking your comments

AMIT KUMAR BAID

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