Options trading: Use ratios to take away hurdles between you and the direction

Build a ratio spread by buying a higher call/lower put relatively closer to the stock price, and shorting 2 lots of at least 2-3 steps, if not more, of even higher call/lower put.

We all know that options are one of the finest instruments to trade directions, thanks to their most liked feature of having a non-linear pay-off. You will always make more money from them when the move is favorable than you will lose when the move is unfavorable.

However, with that functionality comes a baggage -- the baggage that justifies the provision of such a favorable pay-off. This is essentially the known devils -- time, and expected volatility -- priced into the premium.

Often, these factors are to be blamed for a winning trade to turn into a less-than-winning trade or a losing trade. Let us take both of them, one by one, and understand when these factors would hurt the most, and then discuss a remedy to the problem so that we can enjoy the benefits of options trading without the baggage.

Time

The decay in time value is a menace like death and taxes, they say. Regardless of anything, option premium depreciates to a certain extent with time. We have learnt to live with it, but it becomes quite painful when this element takes the front seat.

The last 5-7 sessions of the expiry is when the time value decay is at its highest, and that is when the single options bought might actually be outdone in terms of stock price sensitivity by the time value decay.

To resolve this one may create a combination of a short option of a relatively higher call/relatively lower put. But considering the premiums, it does not help much in funding the option buy. The better way to go is to create a ratio.

Build a ratio spread by buying a higher call/lower put relatively closer to the stock price, and shorting 2 lots of at least 2-3 steps, if not more, of even higher call/lower put.

What this would do is fund the option bought and let the trade live for the rest of the expiry. There is a hit that comes from 2 short options when the move is favorable but it does keep bothering less and less as we spend more time into the position.

Just in case this unlimited risk profile is not one’s style of trading, one can always go even higher call/lower put and balance the trade is a scary move is sensed.

Expected Volatility

This is one more pain point, especially on reversal moves, when a fall halts and an upward reversal starts the expected volatility would take a downward turn more often than not. This is natural as building something is always more time consuming than breaking.

In such a situation to save from the losses arising out of a drop in volatility especially when the trade is aimed at making the most of a move after a preliminary reversal move has already taken place, deploy a ratio spread.

Where the drop in expected volatility led premium loss would be more than compensated by the 2 shorts while the long option tries to make the most of the move.

Thus, ratios can help us get over the peculiar pain points of the options trading with a vigil deployment in aforementioned use cases.

Reference - Moneycontrol 

Trading Plan

A trading plan is only useful if you follow it. Following your plan will make you successful, yet many traders circumvent the stock market lesson plans that they have carefully created. They become emotional invested in a trade, to the point where they ignore all warning signs. Remember, when the market corrects itself, which it always does, no position is immune, no matter how strongly your ego may be tied to it.

Many investors have stock market lesson plans that watch as their portfolio values are cut in half or more, yet they will still hold their positions. They may fear being left out of a big gain, or be so deep in loss that they felt they couldn't possibly sell at that point. But even if you believe that all positions will recover from their losses, and the truth is that not all of them will, this is a terrible way to trade.

You tie up too much capital, and your rate of return plummets. Just as you shouldn't become emotionally involved in a trade, you should also never become tied to ideas. By this I mean becoming so fond of a particular strategy or trend that you cling to it even after it has stopped working. You need to have strategies, and to have plans, but you must also be aware of the shifts and swings of the market, the beginning and the ends of trends.

When you first form your plan for a trade, you should consider what price or price range you think the stock is likely to reach. This is often called a target price, which gives some traders the wrong impression. A target price is not a price that the stock has to meet. A stock does not have to do anything. If you treat your target price as a goal, it can lead to many problems. Your target price should only be used as a guideline.

The target price helps you figure out your risk to reward ratio, and it gives you an exit point in your trade. At the least, it should give you a point where you'll reassess the trade's ability to continue to moving upward. But your trade may never reach your target price. Many market factors can interfere with its progress, and you may have set your target higher than you should have. Since there's no way all your trades will hit your price targets, it is a good idea to sell half your position at a more conservative target. Routinely taking profits will reward you in the long run.

There are a number of things that can interfere with a stock's movement and force you to close your position sooner than you'd anticipated. Your stock market lesson plans should cover all of these possibilities, but here are some reasons that should always prompt you to close a position:

1. The end of a trend. All trends end some time, and you should be prepared for this.

2. The stock's upward movement has slowed or been abruptly broken, ending its momentum.

3. The stock is approaching a major psychological barrier, perhaps reaching 100 dollars or 200 dollars a share, which should have been anticipated in your plan

4. The stock is about to reach a resistance level it has been unable to break through before. This technical barrier should also have been anticipated in your plan.

5. A sudden market wide decline, or the threat of one, or some other serious uncertainty,  which leads to unsafe market conditions.

Exiting a losing trade is not a big deal. Ending a position whether or not the stock reaches its target price, in accordance with your stock market lesson plans, is good trading. The best traders would rather lose a small profit than take an unnecessary risk. You don't have to win on every trade; no one does, and it's dangerous to try. In fact, by limiting losses, a good trader can be profitable overall, and make money on only 40 percent of his trades. Cut your losses and start fresh with something else when you need to. You'll be happier, and you'll make much more money

5 Warren Buffett mantras that can help you invest better

When stock markets turn volatile many investors find it difficult to stay the course. Some investors want to sell off and want to hoard their cash. Some prefer to start buying the stocks that are falling the most. But such knee-jerk reactions may not create wealth for you. Here are five quotes of Warren Buffett that may guide you in your investment actions in such volatile times.

It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.

Quality matters. Just because a company has fallen 20% from its 52 week high does not make it a great value buy. Do check the fundamentals of the company. Corrections in the market must be used to buy quality stocks for your long term portfolio. Buying them at a fair price makes sense for long term investors. Good businesses tend to compound their profits and reward the shareholders in the long term. Stick to companies that have exhibited decent business performance across business cycles.

Picking up the micro-cap stocks with great potentials may not reward you if the stories do not materialise as expected. If you have a dud stock in your portfolio, use the spikes to get rid of it. Use the proceeds to buy fundamentally strong companies.

Be fearful when others are greedy and be greedy only when others are fearful.

Volatile markets make investors worry about the holdings. Sudden drop in their portfolio’s valuations, make them consider selling out. The same investors were looking for more opportunities when the markets were marching up.

Behavioural issues are a big influencing factor for the retail investors. The emotional swings force them to sell out when it is the time to load up more. Warren Buffett makes it clear that the valuations are attractive when no one is interested in stocks and the other way round.

Someone is sitting in the shade today because someone planted a tree long time ago.

This could be one of the ignored quotes of Warren Buffett. It speaks about the delayed gratification and how it impacts one’s future.
If you sow the seeds in the form of regular investments and let them compound over a long period of time, there is a fair chance that you will see the wealth being created.

Never ask a barber if you need a haircut.

If you buy the idea of long term wealth creation and start investing regularly, wealth creation is not guaranteed. You have to stick to asset allocation and you have to choose the right products that suit your needs.

Many avail the services of investment advisors and distributors. While choosing your advisor be sure that his interests are aligned with your interests.

No matter how great the talent or efforts, some things just take time. You can’t produce a baby in one month by getting nine women pregnant.There are no short cuts – Warren Buffett says. Follow the process and the let the time work for you. The results will be more likely to be in your favour. However, if you try to put your money on tips and get rich quick tricks then you may see some nasty surprises.