How not to lose your shirt in a volatile market!

The layman definition of a volatile market is one where price moves vigorously and unpredictably. A volatile market is a risky market as you know the basic definition of risk is the probability of an outcome to go against your desired outcome. With the increase in volatility, the risk increases. Most of the market pundits would advice to step aside when the market is too volatile or choppy as the trade jargon goes. But like all prohibitive things in life, volatility is fun! It gives you 'apparent' chances of making huge amount of money in very small time frames.

Well sometimes you make money sometimes you lose.

The issue is the amount of money lost during volatile markets far exceeds the amount of money earned. There are some major reasons for the same.

Fear - You buy a stock which, just after you buy, like a bad plot, begin to collapse! It was trading strong so far but suddenly it has started to fall like anything. And by the time, you take 'stock' of the situation; your scrip is quite a bit in red. Now, here the fear kicks in. Just the sheer pace of fall in the stock prices and the multiplying MTM (Mark To Market) losses in your trading account gives you shivers. What if it collapses like the 2008 collapse? I should book the losses now before anything as such happens.

Ego/Inability to accept losses: Fear is just a tad bit better than this. Ego in stock markets can decimate you within days. There are numerous stories of traders putting their ego ahead of their rationale and ending up bankrupt too quick, too soon. A trader suffering from Ego pangs of 'How can I be wrong? This will turn around' generally turn unwilling investors in a falling stock which they actually bought with a trading mindset. Generally, there's a difference between the kind of stocks one trades and the ones one invests.

Taking profits too soon: While one would wait for eternity before booking losses in expectation of a turnaround in a falling stock, but would book profits as soon as it goes above his brokerage payments. It's strange but true that most of the traders leave more money on table than what they grab while trading. The fear that the stock may fall again or the uncertainty of the sustenance of up move in the stock can be major reasons for the same.

Taking positions too early: Another common problem with novice traders. They would employ all their money within 30 minutes of market opening and for the rest of the day; they would be praying the markets to move as per their position. That seldom happens.

Well, there are other issues too which prop up while trading but it's generally one or the other form of the two biggest factors which dictate trading behavior - Fear and Greed!

Those who can control these two emotions make fortunes in the stock markets. Others who can't, help the formers make fortune.

Volatility magnifies these vices. And that's where 98% of day traders lose money..sometimes even their shirts!

I have been using two simple strategies to lessen the impact of volatile markets (and sometimes make the best out of them) for past few months. Both use hedging principle in a crude manner.

Buy and Short around same price: Explaining it with an example-

Buy DLF 150 shares at 175 and short DLF 100 shares at around 175.

Let’s say DLF falls by Rs 5 that day. The long shares show a loss of (150*5) = Rs 750 while the short shares make a profit of (100*5) = Rs 500. By the end of the day, the short shares get settled and the long shares are taken up as BTST/Delivery. 

If the scrip would have moved higher, lets say to 180, the net profit would have been (150-100)*5=250 and the trade would have been settled that day itself.

My broker gives me 5 sessions for settling a BTST position.

As of Day 1, I have Rs 500 of realized profit and Rs 750 as unrealized loss.

Next day, after watching the market for the first 15 minutes, I would take a call on DLF again. If the stock is weak and is not looking to get back to its previous day levels, I would short 100 shares as soon as it falls below previous day's low. Let’s say I manage to short the shares at around Rs 170. The scrip goes down another 2-3 Rs where I see a strong support for the stock. 

A support simply means that some buying may come in the stock due to technical reasons. I would like to take some profits from the shorts and monitor the stock. If the stock manages to bounce back and is supported by a spurt in volume, then it would mean that the buyers are back in the stock. Now, depending upon the volume spurt, I may either add some long positions on the stock or simply enjoy the short covering. However, if a strong support also doesn't hold, I would add more shorts and book some losses on the long shares.

Basically, this strategy helps to make some gains or atleast pare down some losses when the markets are too volatile. As the volatile markets generally show over-reactive moves, this strategy can make money on both sides if used a little wisely with a lot of patience.

On the third day, let’s say the stock has started to move up and has managed to claw back to Rs 172 levels. Your overall position has so far made some 700-800 bucks through shorts while the MTM losses have also been trimmed. Now, a small short position can be opened at the instance of a resistance. Generally a 3-day chart of the stock should be used while determining such supports and resistances.

This strategy works quite well if the market is choppy. It's not a protection against a 40% kind of fall as was witnessed in some of the stocks in recent months. However, this strategy gives you time to think your next move in times of chaos!

The next strategy is tailor made for such situations where the stock is seeing tremendous volatility. It can make the best of a 40% kind of fall if luck may have it. However, this works only when there is increased volatility (or one way movement - up or down) in a stock.

Long (Out of money) Strangle: I generally prefer second or third out of money quote on both sides to keep my risk money low.

Let’s take an example:

 

Screen clipping taken: 22-Jun-13, 12:06 AM

This is Reliance Capital's June Option Chain taken on 22nd June 2013. The spot price of the stock was 319.6 as per that day's closing.

I would buy a call option of 340 or 350 while a put option of 290 or 300. These are sufficiently out of money and thus would need a very small premium. If I buy a 300 put at 1.3 and 340 call at 1.3, the total premium charged is 2.6. Reliance Capital has a 500-share lot. Thus, the total amount committed is Rs (2.6*500) = 1,300.

Now if the stock gives a big swing on either side, let’s look at what happens:

Using the Black & Scholes Option Pricing Calculator with some assumptions, we get the presumptive prices of the premiums.

Spot Price	Max(Put Premium, Call Premium)	Profit
290 (-9.35%)	30.17	(30.17-2.6)*500 = 13,785
300 (-6.25%)	20.69	(20.69-2.6)*500 = 9,045
340 (+6.25%)	20.66	(20.66-2.6)*500 = 9,030
350 (+9.35%)	30.04	(30.04-2.6)*500 = 13,720

Now, as I have already mentioned earlier, this example has incorporated a lot of assumptions which any experienced options trader can easily see through. Using the 'Single-Strike-Price-Movement' chart would have been more precise. But this is for the sake of simplicity.

This strangle employs very small amount of money and can give handsome returns. Once a volatile move is done on any one side of the stock, the profits on that arm of the position would be enough to compensate for the other arm's premium. Now the other arm can be left to expire as it is. However, if the volatility again plays on the other side, it may make you twice lucky.

This is not as simple as it looks.

What if there are no outrageous moves? Both sides of the trade lose premium and both side may expire at zero on settlement/expiry day. That's the maximum risk one carries in this strategy.

There are ways to mitigate this to some extent. And the simplest one is to pick only those stocks which have very high beta or trade on only those stocks which are expecting some strong news (like Quarterly earnings).

Here's a list of stocks which have been the most volatile in the last one year:

*Pantaloon Retail is now Future Retail Ltd. (FRL)

*There could be some changes in the lot sizes of some stocks

All these stocks are atleast two times more volatile than the index and thus are well suited for the strategy above.

Again, this is a very simplified version of the actual strategy and thus a little skill and knowledge is expected before one employs this.

On the day of results, one particular stock deserves to be played using this strategy. And that is Infosys (Infy).

For the past few quarters, Infy has been seeing extreme movements on one side after releasing its quarterly results. Last time it fell more than 20%. A similar strategy would have cost Rs 1460 (actual figure) a day before the results while would have earned more than Rs 12,000 by the day close.

Well, hope some of these make sense to the readers.

Stay protected :)