Note: Protective put is also known as married put. Last year I had written an article on married put, but I think it was not well explained. So I am writing it again in details with more explanation and examples.

How many times has it happened that you bought a stock and it moved up, remained there for some time and then came crashing down before you could even book profits. You were not in a mood to book profits, thinking that the rally isn’t over. But exactly opposite happened. Sorry if it has happened to you. But the fact is you should have booked profits or bought a protective put.

What is a protective put?

If you buy a stock/future and the stock rallies, you are making a good profit. But this profit is just on paper as you got to sell the stock to book profits. However you are certain that the rally isn’t over yet and you do not want to sell the stock. In that case what can you do? If you sell the stock, any further rally has no meaning for you as you are out of the trade. You booked your profits and you are out.

In such a situation where you want to participate in further rally and make sure the profits made so far are not lost, you can buy an ATM (at the money) put. Now your profits are locked. How?

Example:

Lets suppose you bought ICICI bank stock when it was at 1000. The stock rallied and reached 1100. You are sitting at 10% profits. But its election time and you are sure the stock may rally 10-15% more. But anything can happen in the stock markets. To make sure you do not lose what you have already made, you but an ATM put. Since the stock is rallying, the puts will not be costly. Why? Because market players will pay more to buy calls as the stock is moving north. Who will pay more for puts when everyone knows that the stock is moving up?

Please note that if volatility is high, both the calls and the puts will be costly irrespective of the direction of the stock. This is done deliberately by the market makers to make sure there are no arbitrage opportunities. Can’t explain this in details. But just in short – if the puts were very cheap compared to calls – market arbitragers will buy both the calls and puts and make money if the stock moves in any direction fast. So why is this a problem for the markets? All professional traders will become arbitragers. The sellers will lose for certain. Markets should be a place giving equal opportunities to everyone. Arbitrage opportunities are not good. If every time arbitragers win, you and I will leave trading or join the arbitrage group. If there is no other group, there will be no trading.

If you now buy a ATM put, your profits are protected. However nothing comes for free. To play the up-move that may or may not happen, you got to pay a price. This price is the price you pay for the puts. Depending on volatility the price of ATM put of the current month may be 3-4% of the profits you are making. So it could be 30-40 odd points. Remember your profits are 100 points. Therefore if you think there is a 10% move still left and you want to play for that move, you have to pay 3-4% of what you have already made to protect your profits.

Now if the stock moves up, you will make money from the long shares/futures, but you will lose money in the put you bought.

If ICICI bank actually moves up 10% more to 1210, you can book your profits. Your profits will be the profits minus the price you paid to buy the puts. Remember if the stock goes up and finishes above the put strike price, the put will expire worthless. You will get nothing when you sell the put.

Of course if you think the rally is still not over, you may have to buy the next month’s ATM put. This depends on your view of the stock. However there is a saying in English – don’t push your luck. For traders its advisable that you book your profits and look for opportunities elsewhere. A 20% fast move is rare. Book your profits, don’t be greedy.

Still you can keep doing this till the rally is over. The only problem is that your profits will be reduced by the money you paid to buy the puts.

However there will be time when the stock will not move any further and slide down. The protective put will now do its job. How?

Lets take an example.

Step 1) You bought a stock at 1000.

Step 2) The stock rallies to 1100. You are confident the stock will move up even more.

Step 3) You buy a protective at the money (ATM) put at strike of 1100 by paying for 30 points.

Step 4) You were wrong. There was bad news in the company and the stock starts to come down. You are least bothered because you have bought the protective put.

Step 5) By the end of the month the stock reaches 900. 10% lower than your buy price.

Step 6) You close both the positions. You are in profits.

Calculations:

Loss in the stock 900 – 1000 = -100 * 250 = -25000.

Profit in the protective put: The 1100 put will be at 200 (1100 – 900).
The profits = (200 – 30) * 250 = 42500.

Total profits = 42500 – 25000 = 17,500.

In fact your profits are protected wherever the stock closes. Anywhere below the strike price of the put, you will make a profit of 17,500.

Now this isn’t over yet. What happens if the stock keeps rallying?

What happens if the stocks moves up and you want to book the profits at 1200? You will make even more money.

How?

Calculations:

Profit from the stock 1200 – 1000 = 200 * 250 = 50,000

Loss from the put: The put expires worthless. The cost of the put = 30 * 250 = 7500

Total profits: 50000 – 7500 = 42,500.

You will make more if the stock keeps rallying.

Isn’t the protective put a great option? Yes it is. It protected your profits and it also allows you to play the rally without worrying about the stock going down.

Important point: You know what the professionals do? They buy the protective put as soon as they buy the stock. Yes they are willing to pay a price to make sure they are not stuck at a stock if there is a huge decline. Overnight the stock may open in a huge gap down. In that case the put will make money and they can get out of the stock at a small loss.

Therefore hedging is important whenever you trade.

But remember protective put comes at a cost. So if you are long term investor and want to hold the stock for a long time, the protective put is not required. Since you are holding the stock and willing to wait to reach your target price – buying a put will be of no help. When trading everything has a purpose and we trade with a logic.

Buying a protective put for long term traders has no logic and does not solve any purpose. Yes suddenly one day if the stock jumps and you want to protect your profits – a protective put will be of help.

But if trading a stock for the short term (not intraday) – a protective put is a great trade to protect your profits.

Why not intraday? Because traders playing intraday have a stop loss in the system already and if the stock reaches that point the stop-loss gets violated and trade stops. What does a protective put do here? Nothing.

For intraday trading the best hedge is to sell calls if buying, and sell puts if selling the stock. Protective put will be of little help here as the Intraday traders book profits or losses in small movement of the stock. Protective put is meant to protect your money if the stock moves down substantially.

For positional positions short-term, if you have bought a future or equivalent value of stock, a protective put will be of great help if the stock declines.

Smart traders will actually put a stop loss to the put if they see there is no chance the stock will reverse direction if it is moving north. That way they reduce their losses from the put. But this can be risky.

I usually do not get out of the put until I get out of the stock itself. I therefore do not recommend a stop loss in the puts. Sell put when you sell the stock. I am a conservative trader and I love to remain that way.

Some people might think why a trader does not lose money if they buy the put and the stock rallies. That is because the put does not shrink in value the way the stock increases in value.

Put will not reach a worthless figure before the last trading day (probably hour). It will retain some value until the last hour of the last trading session of the month even if the stock has rallied a lot.

I hope its clear what’s the actual job of a protective put. Its strange how most traders in India feel its a waste of money to buy protective puts, until one day they see their stock crashing.

Have you ever bought a protective put? If yes, has it helped?

How many times it has happened that you bought a share and it started to fall? If you plan to hold it for sometime than it is OK not to worry and keep adding more of it if you think the stock will eventually go up in a few days.

But what if you have bought it from a trading perspective? What if you do not want to hold the stock for long? What if you bought a future of a stock and the stock starts to fall? You start to lose money immediately. The future will expire in a few days and there is no way to know if in that time frame your trade will be profitable.

This stock loss repair strategy will help to bring the stocks price down, and not eliminate the losses. If you can bring the stock value down – you are averaging its cost and if it goes back to its original buy value – you can make a profit. Some of the time it will happen, some of the time it won’t. Therefore the risk is yours.

However I recommend that you read this strategy and understand how it works. If you do not understand anything or want to share something with other visitors of this blog, please share your thoughts in the comments section below.

Lets discuss the strategy.

When do you implement the stock repair strategy? When the stock you bought has fallen to an extend where you are not comfortable holding it.

Now there are two things you can do to stop your losses:

1) Sell the stock and restrict your losses, or
2) Buy a put, or
2) Implement the Stock Loss Repair Strategy.

Here we discuss how to implement the stock loss repair strategy:

Lets suppose you bought Nifty Future at 6000 hoping that Nifty will go up. But Nifty started to fall. It has reached 5800. Right now your losses are 6000-5800 = 200 * 50 = Rs. 10,000.00.

You are uncomfortable holding the trade but somehow you feel that Nifty will go up. You can then implement the stock repair strategy.

What do you do?

You buy one ATM (at the money) call option, and sell two OTM (out of the money) call options. You just implemented the stock loss repair strategy.

Lets see the outcome:

Suppose the value of the 5800 ATM call option is: 120

And the value of the 5900 OTM call option is: 90

Your account will be credited with:

90*50*2 = 9000
120*50 = 6000
9000 – 6000 = 3000.00

Note: By implementing this strategy please do not think that all losses are eliminated. The downfall risk is still there. Which means that if the stock continues to fall, you will lose money. However by implementing this strategy you have reduced the cost price of buying the stock/future. And by reducing the cost price you have given yourself more chances of making money.

How does the cost of the stock gets reduced:

You see your account got credited by 3000. Which means right now you are only losing 10000-3000 = 7000. This means effectively you have brought down the buy price of your Nifty future by 60 points. How? 3000/50 = 60. It also means you have now a long Nifty future bought at 5940 and not 6000. If by expiry Nifty does not move anywhere you will lose only 7000 (plus commissions) and not 10000.00. Well you may recover your money if by the end of expiry Nifty reaches 5940. In fact if Nifty expires above 5900 you will end up making a good profit. Remember that 6000 was your initial buying cost, and because of this strategy you can make a profit even at 5900. But there is a twist. We will see what it is.

But before that an Important Note: Please do not get excited. This is not a golden strategy. Please do not repair an already repaired stock. What I mean is that if your stock keeps falling even after repairing, you got to take a stop loss. If you think you can buy another call and sell two more calls to reduce your buying cost even further – then you are doing a trading blunder. If you do so you will be naked one call sold. (4 calls sold, 2 calls bought and one long stock). If your stock does not reverse, you are fine. But if it reverses (more often than not it happens), you will be at unlimited loss in the naked sold call. So please do not over trade. Just exit if the position if its not comfortable to hold. And that is the best adjustment you will do.

Profit and Loss Calculations:

The downside risk is still there. That is if Nifty keeps falling even after the stock loss repair strategy is implemented, you should consider quitting the trade. No point in calculating the losses as the stock can go to zero. Just keep in mind that you should have a Max loss in mind. If that is hit, just take the stop loss. You are still better than people who did not do the stock repair strategy. Your losses were reduced by Rs. 3000.00.

Now lets see what happens if the stock reverses the direction.

Stock bought at 6000. Stock repair strategy done at 5800. If Nifty expires here, others with the same strategy lose Rs. 10,000.00, you lost only Rs. 7000.00 as you gained 60 points overall due to the strategy. 3000 saved.

Nifty now reverses.

Expires at 5900:

Loss from the future bought: 6000-5900 = 100 * 50 = -5000.00
Loss from the call bought: 120 – 100 = 20*50 = -1000.00 (at 5900 the 5800 call will be 100)
Profit from the sold calls: 90*50*2 = +9000 (both calls expire worthless)

Total Profit: 9000-5000-1000 = 3000.00

Note: Had you not implemented the strategy, you would have lost 5000 if Nifty expired at 5900. But here you make a profit.

Nifty Expires at 6000:

Profit from the futures bought: 6000-6000 = 0*50 = 0
Profit from the call bought: 200-120 = 80*50 = +4000 (at 6000, 5800 call will be 200)
Loss from the calls sold: 100-90 = 10*50*2 = -1000 (at 6000, 5900 calls will be at 100. They were sold at 90, so the difference is 10.)

Total Profit: 0+4000-1000 = 3000.00

Note: Had you not implemented the strategy, you would have made no profit and no loss if Nifty expired at 6000. (Actually you would have made a small loss because of the commissions involved in so many transactions. Do not ignore the commissions.) But here you make a profit.

Nifty Expires at 6100:

Profit from the futures bought: 6100-6000 = 100*50 = +5000.00
Profit from the call bought: 300-120 = 180*50 = +9000.00 (at 6100, 5800 calls will be at 300.)
Loss from the calls sold: 200-90 = 110*50*2 = -11000.00 (at 6100, 5900 calls will be at 200. They were sold at 90, so the difference is 110.)

Total Profit: 5000+9000-11000 = 3000.00

Note: Had you not implemented the strategy, you would have made 5000 if Nifty expired at 6100. But here you make less profit. And that is the cost you pay because you got nervous and implemented the stock loss repair strategy.

Needless to say you will not make any more profit than Rs. 3000.00 anything above 5900. The two sold calls will eat all the profits and you will have a limited profit of 3000.00.

That is the trade off. If you are happy with that limited profit, you should implement the strategy or wait for the stock to reverse. We all know hoping that the stock will take the direction of your trade is a useless hope. It seldom works if ever.

Stock repair strategy is great if you are losing money on a stock and feel that it may reverse soon but not much. If it does, good for you. Else you should exit if it hits a point where you feel uncomfortable. Feel lucky that you still lost less just because you implemented the strategy.

So, have you ever implemented the stock loss repair strategy. What was the result?

Diagonal call spread is traded when you are slightly bullish but think that markets will remain within a range for the next 25-30 days. In simple terms when you think Nifty will rise but not more than 200 odd points during the month and stay there.

So you must be thinking, why not trade call credit spreads which will also produces profits. Well if done right, Diagonal Spreads can make more money than credit spreads. We will know how.

Note: Since they can make more than credit spreads, its quite obvious that these are also complex strategies and may not be suitable for a less experienced trader. Moreover it is more risky than credit spreads. I recommend that you first try credit spreads and then try your hand at diagonal spreads. Don’t think about the profits, think about the risks first while trading and you will be a good trader.

How to create a diagonal trade?

Note that I am discussing here the diagonal call spread only as an example. You can also play the diagonal put spread. Diagonal Put Spreads are same except you sell a near month put and buy a far month put for protection of different strike. Everything else remains the same.

I hope you know about credit spread trade. The diagonal trade is somewhat same except the insurance you buy will be of different month (not of the same month).

For example you can sell one call option of the current month. This option lets say expire in about 30 days. Now what will you do if you were to create a credit spread? You would buy a call option of a higher strike price than the option sold to make it a credit spread. However in diagonal spread, you would not buy the option of a higher strike of the same month, but that of the next month. This option should expire after the option that is sold. It could be next month or next to next month. It depends on your view. However to keep things simple most traders sell option of the current month and buy option for protection of the next month. This completes a diagonal spread.

Example:

Lets say Nifty is at 6500 and you think that in the next 30 days it will reach 6700 and stay there for some time.

To trade a diagonal call spread you would:

1. Sell a current month call option strike 6700.
2. Buy next month call option strike 6900 or any other OTM strike. I will explain a bit more about this a little later.

Selling the near month option will give you cash. But since you are buying next months option – your account will be debited. Depending on the value of the options sold and bought there will be a credit or a debit to your account.

If the option you sold had more points that the options bought – your account will be credited.

If the option you sold had less points that the options bought – your account will be debited.

The ideal situation is – If you can get a credit to trade diagonal trade. Then we will learn how you can ride the markets for free. Therefore most professional traders prefer a credit while trading diagonal trade.

What happens once you have bought a diagonal spread?

So you have done the diagonal trade and your are exited because you got money while doing the trade?

Well things are not that simple. Here is what can happen when diagonal trade has been done and current month expiry nears:

Scenario 1: The sold option may expire worthless, volatility has increased and the index is near but below the short option:

This is a great situation. You keep the premium received from the sold option and because the volatility has increased you can also sell the bought option for less loss or even a profit. So essentially you made money from both the option sold and the option bought. Remember this a very rare occurrence though. If it happens consider yourself lucky. Your ROI will be significant. I cannot calculate as its very difficult to predict the next months option price. But one thing is for sure, if this happens you make more than you could have from selling a credit spread.

Note: If expiry is near and you see you are making profits in both the options, you should immediately buy back the diagonal spread. Everyday is a different day in option trading and you never know if you will actually make such a good profit next day or on the day of expiry. You are making good money so you should exit. Don’t be cheap, do not wait for expiry to eat the full premium. You may end up in a loss.

Scenario 2: Same as Scenario 1 except the volatility has decreased.

This too is a good result. Since you have a credit, if the short option expires worthless there is no way you can lose money. But your profits depends on the value of the bought option. Because the volatility has decreased you may not get good cash back by selling it. However you have made a profit. But you could have made more had you done a credit spread. Still the ROI should be great.

Now I had said earlier that I will explain a bit more about the bought option later. Remember you had a credit when you traded the diagonal spread? If you are not getting good money back by selling the bought option and your view is that the markets will keep going in the direction of the bought option i.e…. going up if a call, and going down if put, you can actually ride the markets for free. Why? Because you were already paid for the bought option by the option you sold. If you are right you can make unlimited profits from the option bought for “free”. What else can you ask for?

If you ask me, I don’t take a risk. I sell it and look for another opportunity. But for aggressive investors, this may be a suitable strategy. You bought the call for free, so why not try to take advantage? Even if you sell it at cost to cost – with no profits, your ROI will be great.

Scenario 3: Short is breached, index going against the short call, but the long call making profits:

If volatility has increased, there are chances that the value of the diagonal spread has increased too. Frankly in this situation there is no perfect answer, except if it far exceeds the short, the spread will be in loss. Why? Because the short being in the money will start losing value faster than the long call gaining in value. The long call is for next month and is still OTM. The further the indices move away from the short strike, the more the loses. But if it has not moved too far, and the vega has increased, there are chances that the diagonal spread will make money.

Ideally in this situation you should exit even if making a small profit. If it goes too far, I bet you will lose money.

Scenario 4: Index/Stock heading lower:

4a) If volatility has increased: In that case if its still not gone very low than the short strike, it may be that you are getting good value by selling the long and buying back the short. Profits for sure.

4b) If volatility has decreased: It depends. But the profits will be little as the short may have lost most of its value, but the long also may have lost a substantial premium. Therefore you may not make good profits. If done for credit you should make a profit.

In both 4a and 4b, if the indices has gone too far from the short strike and if the diagonal spread was done for debit, then the spread may be in huge loss especially if volatility has decreased.

Some Important points to note:

1. Diagonal spread is a complex trade. It is not as easy as it seems because apart from the movement of the stock, it is also a vega (volatility) play. If the trader is wrong anywhere – he will lose money.

2. Profit comes but you will never know when to take it as greed will take over and you will feel more profits may come. You may be surprised to see next day if volatility crushes and your position is in a loss.

3. Diagonal spreads will produce great profits if the stock stays just below or above the short strike for a long period with volatility increasing. Well this happens often, but how on earth do you time this situation?

Therefore if you are beginning to trade in options its highly recommended that you start with credit spreads or collar strategy and move on to other strategies. You may in fact feel no need to trade any other strategy in your life time.

Important Note: I will discuss Covered Combination in this article, but as a bonus I will disclose a tip that will help you to limit unlimited losses in case the strategy goes wrong. Remember as we will discuss, covered combination strategy can incur double unlimited losses if the trader is very unlucky. But otherwise, and most of the times it is a great strategy. So please read the full post to understand how to limit your losses in this strategy.

How many times it has happened that the stocks in your portfolio do not move much in a month? It happens in most months isn’t it? Only in one or two months in a year either it rises by 10-20% or more or declines by 10-20% or more. Otherwise it stays in a range. The question is how to make money in those months when the stock does not move much and is range bound?

Covered Combination is the answer.

Note: Covered Combination should be done only if you own equal to or slightly more or less than the stock’s equivalent value in a lot in its futures. For example if you are doing it in ICICI Bank (my favorite stock :)), you should own at least 250 shares of ICICI Bank as one lot of futures of ICICI Bank is 250, Or it can be done with futures. But technically speaking Covered Combination is done with shares in your account.

Now lets jump straight to the strategy. The Covered Combination strategy:

It is a mildly bullish to neutral strategy. When you own a lot of shares of a company and its not moving much, you can adopt this strategy to make money while still owing the shares. However if the stock tumbles heavily, you lose money more money than you could have by not entering this strategy. If your stock does not move much, you stand to make a good amount of money than those who did nothing.

The good news is that most of the times the stocks do not move much, but the very bad news is if it falls badly you tend to lose a lot. Another drawback is you make less but do make money if stock continue to rise. So the only drawback of this strategy is if the stock keeps declining.

Lets take an example:

You have 250 shares of ICICI Bank bought at an average value of Rs. 1,000.00 per share and you think for the next one month the stock is not going to move much because the quarterly P/L announcements have been made and the results were as expected by the market. There isn’t much news to follow in this stock so for the next one month or so the stock may move in a range.

On 19-Feb-2014 ICICI Bank stock closed at 1030.90 (NSE Rate). Your view is that till the F&O expiry of March 2014, the stock will not cross 1100 and will not fall below 950. You can trade a Covered Combination for this stock.

You can then sell the OTM 1100 ICICI Bank 27-March-2014 Call. Closing price is: 14.35.

Similarly you can sell the OTM 950 ICICI Bank 27-March-2014 Put. Closing price is: 9.00.

Your account on the next trading day will be credit with:

((14.35 * 250) + (9 * 250)) = Rs. 5837.50 (less brokerage commissions).

If you view is correct and on 27-March-2014, the March expiry day, ICICI Bank trades somewhere between 1100 and 950, you pocket the premium received when you sold the call and the put. Rinse and repeat every month – keep making money, month after month until ICICI Bank breaks the range. You can then look for another stock.

Please note that you were planning to do nothing with the shares anyway and just hold them, so you just made this cash for free. Moreover most brokers will not ask for additional cash to sell the options, the stock you hold in your demat account will act as collateral. You sell the call and the put against your shares as collateral. Please check with your broker, my broker allows it.

Warning: If ICICI bank goes WELL below 950, your broker may give you a warning call to either close the position in the PUT or sell the shares.

Well the fact is you need not bother till the break even point is reached. How do you know the break even point?

14.35 + 9 = 23.35. 950 – 23.35 = 926.65 is your break even point for the put side. We need not calculate the break even point for the call side as the shares will make a profit anyway. If ICICI bank falls further than 926.65, you will incur losses in both the shares and the sold put. A bad situation to be in.

Therefore Covered Combination is a limited profit but unlimited loss strategy.

Another Important Note: You may get aggressive and sell 2 lots of calls and puts thinking that you get double the money so your break even point is even further down. DO NOT EVER do this. Your break even point will not change even if you sell 100 lots. You will be in big trouble if the stock keeps moving south. And you know very well that does happen often.

Trading more than your account size is never recommended. Agreed you may be right in most occasions, but one overnight fall in ICICI Bank will wipe out years of profit and some more and you will be left in a heavy loss. Selling naked options is a dangerous trade and should be done with caution and experience. One lot is fine, because I will tell you a tip that will reduce your income but help you to limit the losses as well.

Again do not sell 2 lots of options of either calls or puts if you have only 1 lot of future or cash invested in the stock. Of course if you have 500 shares of ICICI Bank, you should sell 2 lots of calls and puts.

Now the tip on limiting losses:

Covered Combination as you know by now is an unlimited loss trading strategy. But and this is important, the loss is only when the stock keeps declining in value. If it declines a little and/or goes up a little, you are safe as the call and put both options will also decline in value with time and will expire worthless. You make money from both of them.

If the stock keeps moving up, there isn’t any problem. The put will expire worthless and you can keep the premium. The call will increase in value, but so will your shares.

Lets suppose ICICI Bank on the March expiry day is trading at 1200. The put expires worthless. But the 1100 call will be trading at 100.

Your loss in the call: 14.35 – 100 = -85.65 * 250 = -21,412.50
Your profit from the put: 9 * 250 = 2,250.00

Total loss: 2,250 – 21,412.50 = -19,162.50

Now your profit from the shares: 1200 – 1000 = 200 * 250 = RS. 50,000.00

Total profit: 50,000.00 -19162.50 = Rs. 30,837.50

Agreed had you done nothing and kept the shares, your profit would have been 50,000.00. Now you profits are less, still significant. But think frankly, why would someone wait for so long to sell ICICI Bank shares? How on earth they know that ICICI Bank will go up to 1200 by the end of March?

You waited because you had a reason to wait. You knew that your profits are limited so why sell when only a few days are left for expiry? Ultimately the result was satisfactory. You made a big profit and were already making profit using this strategy. You should be happy with the limited profits. Overall your stocks fared better than people who did nothing with their stocks.

When ICICI Bank was rising, most people would have already sold their shares when it was at 1100 – taking a profit of 10% or Rs. 25,000.00. You are still better than them.

Moreover add to this the premium you collected every month, month after month. Even if for 5 months if ICICI Bank was trading in a range, you would have made 5837.50 * 5 = Rs. 29,187.50 EXTRA if you did a Covered Combination month after month. (This depends on the option prices prevailing at that time. It can be more or less.) Your friends who did nothing with their shares of course made nothing.

29,187.50 + 30,837.50 = Rs. 60,025.00 profit on 1000 * 250 = Rs. 250,000.00

That’s an absolute return of 24.01% ((60,025/ 250,000) * 100) in just 5 months. What else can you ask for?

So what can be wrong? Why people don’t trade Covered Combination and make money on their idle stocks lying in their demat account?

There are two reasons:

1. People think options are too risky and do not trade out of fear, or they just don’t know this strategy exists.
2. The risk is unlimited if the stock plunges.

No 2 is a huge problem. A big decline can take away months of profits and you will really feel bad about your decision for trading Covered Combination. What if this happens in your first month of trading Covered Combination? However there is a trick to limit losses to some extend in this strategy.

What if you make selling the put into a credit spread? You sell one lot of 950 put and buy another lower put for protection.

Since our problem is the put and not the call, we will only buy a put for protection and leave the call naked so that we still get a reasonable premium month after month and still will be able to limit losses to some extend if the stock keeps going down.

Lets see if that is possible.

The 900 March put is currently available for 4. Which means if you buy it you will be protected for losses beyond 900.

You will still get a credit. Sell 950 at 9 and buy 900 at 4. Your total credit is 9-4 = 5.

You still get 5 * 250 = 1250 from the put. If ICICI Bank does not fall below 950 you can keep that premium. But yes if it falls below 945 you will have to take a loss in the put. However since you got 14 from selling the call you are safe till 945 – 14 = 931.

So what’s your Max loss here? 931-900 = 31*250 = Rs. 7750. Below 900, the 900 put will protect your losses. That’s the Max loss you will suffer for trading Covered Combination. Remember this will come ones or twice in a year. In other months you will keep making money from Covered Combination.

Isn’t this an excellent strategy to make money from stocks lying idle in your account?

Disclaimer: Examples given here are should not be substituted for real life trading. These are just examples to help you understand this strategy. When you trade Covered Combination, you might find better option prices or worse. This article does not guarantee that you will make this kind of a return. But such returns are possible, if you look for non-volatile stocks. The only trade off is that non-volatile stocks have low premium in their options.

Will you try Covered Combination now? I will be glad if you do. If yes please write your results. It will be great to share.

Warning: Bull Calendar Spread is a slightly complex strategy. This should be traded by an experienced trader only. Involves some calculations and knowledge.

Lets explore.

This is a bullish strategy. However a trader may not take huge losses even if he was wrong as this strategy involves hedging right from the second the trade begins. I love hedging by the way. Far better than taking a stop loss where you have to keep an eye in the market every time its opened and till it is closed. Tension hover over your head if your positions are not hedged and naked. True you can put a stop loss in the system in the morning itself but you got to do it every time the market opens if its a positional trade.

I always do positional trades. I hate intraday trading. You can’t make a million bucks trading intraday. Kudos to those who are making money playing intraday. But I know they are few and profits are limited or small. And I don’t want to make money that way.

Ok back to Bull Calendar Spread.

Do you know about debit or credit spreads? If not these spreads are hedged where the trader sells one option and buys another for a debit or a credit of the same underlying and for same expiry but different strike prices depending on their view. The position therefore is properly hedged.

Bull Calendar spreads are not very different from spreads but they involved much more understanding. If you can understand, than calendar spreads are better in terms of rewards than debit or credit spreads. The major difference being it has limited risk but unlimited rewards. If you can recall debit or credit spreads have limited risk and limited rewards.

How to Trade a Bull Calendar Spread?

This is bullish strategy. Lets suppose Nifty is at 6000 and you are expecting a move up. But you do not want to take a naked risk, and want to properly hedge your position you can enter into a bull calendar spread.

What will you do?

Sell to open ATM or OTM near month calls – Strike XXX*. (Sold to decrease buying price of next month calls.)
Buy to open ATM or OTM next month calls – Strike XXX*. (Calls gets cheaper because we sold the same number of calls of the near month.)

*Strike XXX means same strike in both the legs.

Let me take an example.

On Feb-13, 2014 Nifty closed exactly at 6000. Closing prices: Nifty FEB 6000 CE was at 78. Nifty MARCH 6000 CE was at 155.

Lets do the bull calendar spread trade:

Sell to open 2 lots of Nifty FEB 6000 CE: 78*50*2 = Rs. 7800.00 Credit
Buy to open 2 lots of Nifty MARCH 6000 CE: 155*50*2 = Rs. 15,500.00 Debit.

Total debit: 7800 -15500 = Rs. -7700.00

This is the traders’ maximum loss. Now whatever happens, even if Nifty gaps down 5%, the trader will lose less than Rs. 7,700.00. This is the limited loss.

Note that less than 7,700 is important we will discuss it later. Which also means that 7700 is NOT his max loss, its much less than that if the trader chooses to close both calls at the same time. If he carries it forward to the next month and waits till expiry then maybe his max loss would be 7700. More later.

Can you sense that risk reward ratio is extremely good in Bull Calendar Spread? If you still do not understand, do not worry, we will discuss it later in this article.

A loss example here is not required as you know that in any case had the trader not sold the near month calls his lost would have been max at 15,500 i.e. the cost to buy the next month calls. He however reduced the risk by selling the near month calls. So he now knows his max loss.

Lets first calculate the possible profits if Nifty starts moving up.

Nifty starts moving up and expires in FEBRUARY at 6200. 200 points up from 6000.

The following is an assumption of the values of the options. The real results may vary.

The Nifty FEB 6000 CE will be: 200
The Nifty MARCH 6000 CE will be around 335. (Its just an assumption, real rates may vary) .

Calculations:

Loss from Nifty FEB 6000 CE: (78-200) * 50 * 2 = -12200
Profit from Nifty MARCH 6000 CE: (335-155) * 50 * 2 = 18000

Total Profit: 18000-12200 = Rs. 5800.00

ROI:

(5800/60000) * 100 = 9.66% or more in less than 60 days.

Warning: Do Not trade this on the basis of what is written here. There is more to a bull calendar trade than what is written here. Its an advanced strategy done by professionals.

Now I had said that 7700 is not his max loss. Why? Because if the trader does not wait till expiry if Nifty starts to move down, and closes both the trades then he losses some from the next month calls, but he makes profit from the near month calls. Note that this was sold as a hedge. Calculations are not possible because we don’t know the exact values of the calls but its only fair to say that in this case the loss will be much less than 7700. The earlier he closes, the lesser the losses.

In fact a bull calendar spread does better if you sell a near OTM call and buy far months OTM (and not ATM as mentioned in this article.)

Why OTM? Because at the time of expiry if the near month OTM expires worthless, the trader keeps the premium but do not sell the next month OTM at the same time to make a larger unlimited profits. So to make profits from both the calls a trader needs perfect timing. The near month calls expire worthless, and the next month calls kept to play unlimited profits.

Can you do this? If you are highly experienced it may be possible but for not much experienced trader it is better to do a credit spread than a calendar spread.

For a bull calendar to be highly successful a trader needs to have a medium term vision of 40-60 days. For example if Nifty is at 6000 and you feel that it will not cross 6200 this month but may cross 6200 and go up to 6300 or above next month, a bull calendar spread done with OTM calls of 6200 will work great. If it works you will be delighted because you make profits from the hedge and the trade, a very rare situation in trading. Therefore in the long run this trade will lose more than it makes and so I do not recommend that you attempt it.

Look at the risk reward: A trader risks less than he pays to buy calls to make unlimited profits. Though agreed unlimited profits comes with a little more risk. But it has a much better risk reward than a naked call buy. Yes if you were right, a naked call will bring more profits than a bull calendar spread, but that’s the trade off.

Even professionals try a bull calendar spread only occasionally and its not their primary method of trading.

Note that there is another trade similar to this and that is a normal “calendar spread”. Again this trade is complex too. We will discuss it later in this blog, but for those who are interested a normal calendar spread is exact opposite of the bull calendar spread.

Here a trader sells a far month option, and buys a near month option. The near month option acts as a hedging tool for the unlimited loss in the next month options and therefore this trade should be closed as soon as the near month options expires. This trade makes profit if the underlying does not move much and the option sold (far month) declines more in value than the near month options. The trader’s profit is the difference. Unlike the bull calendar, in this trade at least one leg will make a loss. Both legs will never make a profit.

Advance trader adjusts an open trade to make it like a calendar trade, as it is a great hedging tool. For example you bought a Nifty 6000 near month call but you see that Nifty is falling, to limit risk you can immediately sell the next month 6000 call to make the trade a calendar spread. If Nifty keeps falling, you make money.

If its confusing don’t worry, we will discuss calendar spreads later in details.

Similarly a bull calendar spread can also be initiated later in a trade. For example you sold the near month 6000 call in the hope nifty will fall, but your view was wrong and Nifty starts to go up. You can then immediately buy the next month’s 6000 call to make it a bull calendar spread. If nifty keeps going up, you can profit.

Interestingly here if there is a huge resistance, you can sell the next months calls for a profit and hope that nifty reverses. If it does and again goes below 6000, you can profit from both legs.

Frankly its easier said than done. In real world taking such decisions will be really hard. But I wanted to share this knowledge with you.

I hope the bull calendar spread is clear. If you still have questions please ask in the comments section.

Another bullish strategy is the call backspread a.k.a reverse call ratio spread. This strategy has unlimited profits with limited loss. As again and I have told this many times in my blog that unlimited profits or unlimited losses are only on paper. You can always take a stop loss or hedge your position.

BTW, I always hedge my positions and get out whenever I feel I have made a decent profits or loss. What about you? 🙂

Call backspread or reverse call ratio spread is good strategy for a volatile market when a stock moves in any direction. But you profit more if it moves up. If it falls you keep the premium received.

The Call BackSpread strategy Explained:

In a call backspread the trader will sell one ITM (in the money) call and buy double or more number of OTM (out of the money calls). Some people say you should only buy double the number of call options sold, but the fact is you should buy more calls than the number of calls sold and this depends on what is your view of the market. If you are absolutely sure markets will move up – buy more than double the number of calls. But on the other side it will increase risk because the premium received will be less than the money needed to buy calls. In that case if the stock falls, you may suffer losses.

Now this “more” depends on how much you are willing to risk. Ok let me explain in details.

The Call BackSpread strategy example:

Let us suppose Nifty is at 5500 and you are bullish. You can sell one ITM call and buy two OTM calls.

Example:
Sell one lot of 5400 call @ 200.
Buy two lots of 5700 call @ 50.

Calculations:
Sell one lot of 5400 call @ 200 = 200 * 50 * 1 = Rs. 10,000.00 (Credit)
Buy two lots of 5700 call @ 50 = 50 * 50 * 2 = Rs. 5,000.00 (Debit)

Total amount credited: 10,000.00 – 5,000.00 = Rs. 5,000.00 credit to the traders account.

Note that the trader to reduce risk can always buy calls with lower strikes, for example 5600 call. But then the credit they receive will also get smaller. If they come even close let’s say buy the 5600 call, the risk gets even less, but then the account gets debited (not credited) and if Nifty does not move much or even closes lower, the trader losses money.

So ideally you should go that far to buy calls that make sense. Same is the case with selling calls. You got to be sure that the premium you receive is something you are comfortable with. Selling OTM calls and buying deep OTM calls will be useless. The premium you receive is also important.

There is another twist to this strategy. If you do this with really very deep in the money calls and get a good premium, you would want Nifty to fall and expire somewhere near the strike price of the sold call – because in that case you will be happy to keep the premium.

This is in total contrast to what this strategy stands for – a bullish strategy. But then why people don’t trade this with deep in the money calls? Because the losses can be heavy if Nifty expires somewhere in between the bought call strike price and the sold call strike price. The trader in that case loses the money they used to buy the ITM calls and also may suffer losses in the sold call. That’s a worst case situation and as you know, no one can predict Nifty movements.

You must be thinking why the trader will lose money in both the call sold and the one bought. Ok let’s look at the results to clear this confusion.

Situation 1) Worst case: Nifty expires exactly at 5700:

Loss from the 5400 call sold @ 200: 5700-5400 = 300. (200-300) * 50 = -5000.
Loss from 5700 call bought @ 50: 5700 calls expires worthless. Money the trader used to buy these calls is now 0. A loss of 50 * 50 * 2 = -5000.

Total loss = -5000 + -5000 = Rs. -10,000.00.

I hope now the confusion is cleared. The trader losses money in both the sold calls and the bought ones. However the good news is that this is the maximum he will lose. The trader cannot lose more than that.

Tip: Whenever you trade options you should have a bail out point. Even before you start trading you should know what’s the Max loss you will take in the trade. Once it is reached just exit the trade and do not look back. Move to next trade. Trading is all about risk management, not about making money. If you are trading to make money eventually you will lose.

Situation 2) Average case: The view was wrong Nifty expires below 5400:

Loss from 5700 call bought @ 50: 5700 calls expires worthless. Money the trader used to buy these calls is now 0. A loss of 50 * 50 * 2 = -5,000.00.
Profit from the 5400 call sold @ 200: 5400 call expires worthless. The trader keeps the premium. 200*50 = Rs. 10,000.00

Total Profit: 10,000.00 – 5,000.00 = Rs. 5,000.00.

Situation 3) Best case: The view was right Nifty expires at 6000:

Profit from the 5700 calls bought @ 50: 6000-5700 = 300 – 50 = 250 * 50 * 2 = 25,000.00
Loss from the 5400 call sold @ 200: 6000 – 5400 = 600 – 200 = 400 * 50 = 20,000.00

Total Profit: 25,000.00 – 20,000.00 = Rs. 5000.00

Note that Call BackSpread is an unlimited profit strategy. If Nifty closed at 6100 profits would have increased.

(350*50*2) + (-500*50) = 35000 – 25000 = Rs. 10,000.00

As you can see from the above the trader suffers losses only if Nifty expires anywhere near the strike price of the calls bought. Now my question is will a trader actually wait till the expiry?

He will have a target in mind. If he is making a profit he should close the position and exit or if his stop loss is hit, again close the position. It is never a good idea to wait until expiry for any option bought or sold.

I have given the results as per the expiry because it is very difficult to know exactly what prices the options will be when they have not expired as it depends a lot on volatility, time and other factors. It will not be fair on my part to assume the prices and explain the results.

What happens if a trader buys the same number of lots and sells the same number of lots? In that case it becomes a call credit spread (and not call backspread) strategy in which a trader wants the indices to stay below the strike price of the calls sold. If the stock or the index moves north, the trader loses money. But in the backspread they make money if the index moves north.

So which one is a better strategy? The call credit spread or the call backspread. It depends on the situation. If you think there is big news coming and Nifty may move up, but the lack of news or negative news may take it down – you should implement the call backspread strategy.

Another Tip: Once the news is in and your view was right and Nifty starts to move up, you can buy more ATM or slightly OTM calls up to a level of risk you can take. But if the opposite happens, just convert it to a call credit spread by selling more ITM calls.

You can go for a call credit spread when you are sure index will not move up – i.e. stay where it is or move south.

If you have any confusion you can ask in the comments section.

In my last article I wrote about bull call debit spread. In that strategy if a trader is bullish, they would sell out of the money calls and buy at or in the money calls. Or they can enter into a bull put credit spread.

Note that a put credit spread can sometimes be more profitable than the bull call debit spread. Very soon we will know how and why.

First what is Nifty Bull Put Credit Spread?

In this strategy a trader would sell a higher level put and buy a lower level put as insurance against unlimited losses in the short put. The lower level put acts as protection in case Nifty keeps going south.

Can you recall bull call debit spread? This one is exactly opposite. Here the traders account is credited but with bull call debit spread the account is debited. Though both the trades assume Nifty will move up.

As always lets take an example.

Lets us suppose that Nifty is at 5400 and you think it has bottomed out and is poised to go up. You can enter into a Bull Put Credit Spread.

Here are the two steps you need to take. Note both trades needs to be done at the same time. Or you can set up a limit order close to the market so that both of them get traded simultaneously.

1. Sell 5300 Put for the near or far month. (Done for credit)
2. Buy 5200 Put for the near or far month. (Done at debit and bought for insurance)

Suppose 5300 Put for the far month is trading at 125 and the 5200 at 100, your account will be credited with 125-100 = 25 * 50 * no. of lots. For example if you sold 5300 2 lots, and bought 5200 2 lots, your account will be credited with 25*50*2 = Rs. 2500. If you sold 4 lots then your account will be credited with 25*50*4 = Rs. 5000.

Math:

Sold 2 lots 5300 PE at 125 = 125*50*2 = 12,500.00 (+)
Buy 2 lots 5200 PE at 100 = 100*50*2 = 10,000.00 (-)

Total credit: 12,500 – 10,000 = Rs. 2,500.00

Your profits? If Nifty closes anywhere above 5300 on expiry both the options expire worthless and you keep the premium received.

Your Losses: If Nifty closes anywhere below 5300-25 = 5275 on expiry you will have a loss, but this loss is capped. Note that 5275 is the break-even point because here you will make 100 points profit from the 5300 sold and since 5200 will expire worthless you lose 100 points there. So 5275 and below you start making a loss.

Loss explanation assuming 2 lots in each leg were traded.

Nifty closes at 5200:

5300 put will be at 100. You sold at 125 and bought it back at 100.
Profit = 125-100 = 25 * 50 * 2 = 2500.00

5200 put will expire worthless. You bought at 100 and sold at 0.
Loss = 0-100 = -100 * 50 * 2 = -10000.00

Total loss: 2500.00 – 10000.00 = Rs. -7500.00.

That is it. Your losses are capped at -7500.00 and you cannot lose more than that where ever Nifty closes.

For example if it closes at 5000.

Loss from 5300 sold put: 5300 – 5000 = 300*50*2 = 30000 – 12500 (the credit you received) = 17,500.00 (LOSS)

Profit from the 5200 put bought = 5200-5000 = 200*50*2 = 20000 – 10000 (the amount you paid to buy 2 lots of 5200 put) = 10,000.00 (Profit)

Total loss: 10,000.00 – 17,500.00 = Rs. -7500.00

As you can see you losses are capped at 7500 and profits at 2500 for 2 lots.

Here is the diagram for payoff in the bull put spread:

As you can see profits as well as losses are capped.

You must be thinking why I took the example of far month and not the current month. This is because for the current month you may not get a good credit worth enough to take a risk. For example the difference between 5300 put and 5200 put in the current month may be just 10 and therefore the credit you receive will be Rs. 1000 (10*50*2). Is that worth to take a risk? Trading is nothing but risk management. For a small sum as Rs. 1000 are you willing to risk a lot of money and time. Agreed the loss is also limited, but I always think and do my math for the worst possible scenario for the trade. If I feel the trade is worth, I go ahead else I wait for a better opportunity.

This by no means is to say that it is a good idea to sell the next months contracts always. The above was just an example. If you do credit put spread and are getting good credit for the near (current) month trades, then go ahead an do it. But just have a look at next month premiums as well, if you think you are better off trading the next month – you should trade the next month contracts.

Also remember that by trading next month options you are taking slightly more risk, you are giving markets more time to move against your trades and therefore are getting slightly more credit. You should evaluate credit vs. risk whenever you are trading put credit spreads and take a decision. Never be in a hurry to trade. Think, do some math and then trade. Moreover wait for the right trade, markets will give you the opportunity sooner than you think.

I had also written that this strategy may be more profitable than the bull call debit spread. You must be thinking why. Isn’t both a bullish trade and therefore should bring the same results? Well you may be surprised.

In options time and volatility has a big role to play during the trading period. When the markets are falling everyone is buying puts and willing to pay extra premium to buy puts.

Moreover when the markets falls, there is fear all over and the fear meter “the volatility” increases. This in turn increases the premium of the puts. And since the values of puts increases, the value of calls also increases. This is done to prevent option buyers do arbitrage. (Well out of scope for this article so lets leave it to that.)

Any market expert on options will tell you to sell an option if the volatility has increased rather than the other way round. This is because you will get a good credit when you sell options when the volatility is high. Now when the markets will bottom-out they will start moving north. This is when the fear will decrease and, as you may have guessed, the volatility will drop. Mirroring it the premiums in the options will also drop. You know what, if you have sold options you will soon see your trades in profits even if the markets stay at the same level and volatility drops.

Now lets look at someone who has bought options when the volatility was high. They will be surprised to see the value of the options refusing to increase even when there prediction was right if volatility drops. If the markets do not move fast upwards, unfortunately time will come in and eat further premiums. That is why one of my articles focuses on why its hard to make money buying options. Unfortunately because of the volatility drop and time passing, the bull call debit spread may not make as much money as the put credit spread trade will make.

In fact the bull call debit spread may even make a loss while the put credit spread makes a profit. When the losses as well as the profits are capped, which one would you trade?

Note: Well it may not always be true, as it depends on the market conditions at that time. If markets move up very fast and for some reason the volatility does not drop, the debit call spread will also make money an sometimes more than the put credit spread. If the trader is very lucky they make money on both the bought option and the sold one. But that is only possible if they wait till expiry. For example if a credit spread was done on 5500 call at 90 (buy) and 5600 call at 60 (sell) and Nifty expires exactly at 5600 – both the options will make money. 10 + 60 = 70 points profit. But these type of trades are impossible to predict.

As you can sense, its always a better option to get into a credit put spread than a debit call spread if you are bullish of the markets and volatility is very high. Even if markets stay just above your short option, in the credit spread you will make money, but with debit spread you will lose money.

If you are absolutely certain of a bullish move, you are better of buying naked calls and take a stop-loss if it does not happen.

Very Important Note: When trading spreads never wait till expiry. Whenever you see a good reasonable profit, you should exit the trade. This is because any market whipsaw may take your profitable position to a loss making one. So even before you put on the trade you must know your bail out points. That is you should know when you will take the profits out and close the trade or when you will take a stop-loss and close the trade. Once done, do not change your strategy.

Most traders lose money because they keep hoping that markets will ultimately favor them and turn around and give them profits. That day never comes and the trader takes a stop loss. You know what just after they take a stop-loss, markets starts to move in the direction in which they wanted it to move. Unfortunately by that time they have stooped out with a big loss.

Read this article once again to get the finer points. I am sure if you follow the strategy written here you must be able to trade well and make profits more than the losses.

Happy Trading!

Note: There is a trick to make more profits in this strategy at the end of the article. But please read the whole article to better understand that trick of making consistent profits form Nifty Bull Call Debit Spread strategy.

Most traders in India who do option trading buy calls or puts. I prefer selling credit spreads as its suits my trading personality well. However I can understand the psychology behind buying calls and puts as it is a limited loss and unlimited profits strategy. But the risks buying options presents is the melting of premium as time passes. So people who buy options will have to race against time as well. Buying options is a zero sum game, where you will win 4 times and lose 5 times and mostly buying options does not make any money over a long period of time. (It is my view and I may be wrong for someone who is making money consistently buying options.)

Well it does when you are right. So why not limit your losses when you are wrong? Why not sell a OTM (out of money) call option? That way you save money while buying the call option and even when you are wrong your losses are limited giving you enough time to stay in the market. One day whipsaw can take your position in profits.

When you hedge your bought option it is called an option spread. When you get a credit (selling an option that has more points than the one that you have bought to hedge) – its called a credit spread. Similarly when your account is debited (buying an option that has more points than the one that you have sold to hedge) – its called debit spread.

This article discusses a Bull (Call) Debit Spread.

If you are confused by the name don’t worry, we will discuss the same right now!

What do you do when you think nifty may go up? You buy ATM (at the money) or ITM (in the money) calls. Right? (Please don’t buy OTM calls – they may be cheap but to generate money nifty needs to move swiftly and significantly in few hours or trading sessions. If it doesn’t happen the OTM options will lose value fast and you may have to sell them at a loss even if your view was right. Follow this strategy if you only buy OTM options.)

Lets suppose Nifty is at 6300 and you want to go long. You buy 6300 CE. Currently Jan14 6300 call is valued at 120. Lets say you buy 2 lots costing you 120*50*2 = Rs. 12000.

Now you are risking 12000 and it is up to you to risk this whole amount or hedge it. Jan14 6400 call is currently valued at 75. What if you sell this call? How much risk does this reduce? Lets see.

Buy 6300 Jan14 CE: 120 * 100 = (-)12000.00 (Debit)
Sell 6400 Jan14 CE: 75 * 100 = (+) 7500.00 (Credit)

Total amount at risk: 12000 – 7500 = Rs. 4500.00

Your risk now reduces significantly from 12000 to 4500. You will still make money if Nifty goes up but lose only 4500 or less if it doesn’t.

So what’s the trade off?

Trade off is that your profits, just like your losses are capped. Now its no more unlimited profits but limited profit with limited loss.

Look at the picture you should understand:

Lets take an example.

Suppose you were damn right (just like right now many trade pundits are predicting) and Nifty moves up 200 points and expires at 6500.

On expiry the 6300 call will be at: 200 (Profit 200 – 120 = 80 * 50 * 2 = Rs. 8,000.00)

But you also sold 6400 call. 6400 call will be at: 100 (Loss 75-100 = -25 * 50 * 2 = -2500)

Total profit 8000 – 2500 = Rs. 5500.

Lets suppose it was a lottery buy and Nifty moved up 500 points and expired at 6300+500 = 6800.

6300 CE will be at: 500 (Profit 500 – 120 = 380 * 50 * 2 = Rs. 38,000.00)

But you also sold 6400 call. 6400 call will be at: 400 (Loss 75-400 = -325 * 50 * 2 = -32,500)

Total profit 38,000 – 32,500 = Rs. 5500.

You get the point? Even if nifty goes up 25% up – you still make only Rs. 5500 – a limited profit.

You must be thinking what a bad strategy. No its not. How many times you will keep waiting for a 100 points profit? As far as I have experienced most traders take a 15-20 points profit and a 10 point stop-loss. And the ratio of win to losses is 6-4 in favor of loss. You end up making less money at the end of month even if you were right most of the times.

Don’t forget that in naked option buy even if the losses are limited – it can quickly add up to lacks. After a year or two you will give up trading for good.

But if you keep a limit to your losses you get more courage to stay in the market because of the hedge. Your losses will be small and your confidence will be more. Eventually a longer time frame will help you to get out at the right time at small profits or at a very small loss.

In the next one month after you trade what is the probability that Nifty may go down and eventually go up and get your trade in profit? A lot. But if you were playing without a hedge you may have taken a stop loss only to see nifty going exactly in the direction you predicted.

You will then rue your decision to take a stop loss. But a hedge will help you to not bother about the stop loss.

Why this strategy is called a Bull Call Debit Spread?

Because your view was bullish.
Because you bought a call and sold a call.
Because your account was debited by Rs. 4500.00 (your max risk amount. Remember 12000 was debited and 7500 was credited to your account. Total debit = 12000-7500 = Rs. 4500.)
And because you created an option spread.

Now the real trick as promised 🙂

If you follow this strategy you should not wait till expiry. Whenever you are in profits – just book profits and close the spread.

But wait till the right time to exit if nifty goes against your views. Eventually within a few days the trend will change and you should be able to get out in small profit. If not you are losing only 4500 – why bother?

I will always vote for hedging than a stop loss while trading. That’s the reason why in my course you will find that all the strategies are properly hedged, so that losses if any are small and negligible, however the profits are good and consistent.

Since I almost always trade nifty options, I will restrict my discussion to options and try to reason why hedging suits me better than a stop loss.

Here are a few reasons why I will always vouch for hedging:

1. No need to worry about your positions. If your view is wrong – the hedged trade is making money. Effectively that is working as a stop loss.

2. You decide when to get out of trade – not a stop loss. In fact you can book profits in one position and leave another position open or initiate another hedge / stop loss strategy.

3. No need to baby-sit the market. You can take time off and feel better. Spend time with your family while still making money. You can leave the trades and go on with your work. Come back after some time to see where you stand and take a decision. In a stop loss, unfortunately though you can leave the system – the stop loss is such a devil that you want to keep watching it and hoping it does not get hit. Eventually it does.

4. Watching one position making money 100% of the time gives more joy. Compare this to the feeling of a position that has just hit a stop loss. 100% loss – no profits.

5. If the trend changes after the stop-loss is hit – there is nothing on this earth you can do about it – except writing a mail to NSE and beg them to reverse the trade which they will not do under any circumstances even if it was their fault. For example a freak trade. You just made a loss and system closed the position. With a hedged position you can leave the trades open for the next hour or day or even few days. More often than not – the trend changes and you can close the trade in profit.

6. You can sleep better in the night as overnight positions can do no harm – remember one positions always keeps you protected. In a stop loss if there is a huge gap opening against your open positions – you will take a stop loss in a market position and see a lot of your money wiped out. It will be a big set back. Some of them can take you out of trading business forever. Hedging will keep you in the game.

7. Sometimes stop loss does not gets executed if the stock/nifty jumps. You are then left at the mercy of the market. Taking a market stop loss will kill you. You will feel miserable for months and will not gather the strength to trade for a long time. This isn’t the case with a hedged position. You will laugh with joy seeing your hedge make a lot of money in a freak second though the other position will be making huge losses. But it will give you time to breath. You won’t freak and press the panic button.

8. Knowing in advance the losses you can make will help you not bother much about your trades so you can take bold decisions and large positions. With a stop loss you can never scale your trades. This is my personal experience that people who put a stop loss never exceed a trade of more than 1 lac. How much will your money grow if you cannot compound? Can you trade 50 lots of nifty call options at Rs. 100.00 even with a stop loss? You have to put Rs. Two lacks and Fifty Thousand on the line. If you somehow felt sick and forgot about the trade and your options expires worthless – all your money is gone. But what happens when you sell a call option with Rs. 75.00 and buy a call option of Value Rs. 100.00? Your maximum loss is 25 points. Now can you trade 50 or even 100 lots? Yes you can.

9. Hedging allows you to do some other work when the markets are open. For instance you can do a part-time or a regular job and still make money. Because there is no need to baby-sit your trades. No need to sit six and a half hours in front of your screen. You have to agree with me here – most traders keep watching a trade if there is a stop loss in the system. You cannot do any other job. Your mind will always be with stop-loss. Period.

10. Hedging ensures capital is protected even if the stock opens gap up or down the next day. Imagine a situation where a trader has shorted a stock with a stop loss of 10 points. 1 point is equal to Rs. 1000/-. It is 3.25 pm and stop loss is juts 1 point away from hitting. Then market closes for trading. Next day the trader is shocked to see that the stock has opened gap up 7%. Imagine his losses. 30-35k lost in one single trade. Had he done a hedge his loss would have been reduced by 85%. There is a future hedged with options strategy in my course. This helps a future trader trade futures fearlessly because he knows that the loses are capped and then profits can be unlimited.

Some people ask me how to hedge when they are trading stocks in cash intraday. You can but you need to buy/sell a stock that has options available. For example you can buy the stock in cash/futures market if you think it will go up and simultaneously buy a ATM put option. So if your view is wrong the put will make money. In fact if you had bought futures and think that eventually the stock will go up – you can leave this position open overnight and see for the next few days. If the stock rises – you can close the position in profit. Had there been a stop-loss you would have never been able to close it in profit as you have already closed the position in a loss.

Some points to remember:

Hedging should be done simultaneously. Suppose you have bought a call you should sell a call at the same time for the hedge to work effectively.

I have seen many traders get greedy and do not buy a hedge at the same time. They think when the time will come they will buy the hedge. That time never comes and they close the position in a loss.

Hedge gets costly over time if not bought simultaneously. For example if you have bought a call and not sold an OTM call at the same time. If your view was wrong – the OTM calls will get less in value and the money you pocket will be less when you close the potion. So your loss will be bigger.

Suppose you had bought a nifty future and did not buy an ATM put at the same time, and nifty falls. The future has already lost some money that the put option may never be able to recover. Again your losses will be bigger.

Suppose you sold a naked call option and did not hedge and the position is going against you. The calls you want to buy for hedging will become costlier (Nifty is rising) and your profits on the calls will be smaller – again your losses will be bigger than what it would have been had you bought the OTM call as soon as you sold the call.

Note: In some trades however stop-loss makes sense. For example if you are a small trader and you trade only with RS. 10000 intraday cash. Then you have no other option but to put a stop loss in the system. You don’t have enough cash to hedge your position.

Most important note: I like hedging better than stop loss. But that is me not you. Everyone has their own psychology while trading. Some like to work with stop loss and some with hedging. Whatever they are comfortable with. This is my choice and not necessary that you should follow it too. Just try both for some time to decide which one works best for your trades and follow it.

But whatever you do – please please please – either put a stop loss or hedge your position or do both. But never play your trades naked. Stock markets are risky investments and should never be traded without proper insurance. Your insurance can be either a stop loss or a hedged position.

So what do you prefer – a stop loss or hedging? Please leave in the comments below.