"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.
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.