Every phase of the market has its unique characteristic and an appropriate approach is required, with the right mindset, to limit losses or maximise gains, as the case may be.
More often than not, investors fall into illusions and trial with a long spell of correction and stagnation, leading to negative portfolio values. Contrary to the expectation of investors, gains are never linear and are mostly lumpy.
Most equity investors participate only on the buy side and do not have a plan to protect the portfolio against the potential swings in the market, which results in sub-par performance.
An investor needs to remember and do some basic research as a big chunk of stock price movement comes only in a few trading sessions. The solution to this is to be a patient investor as equities always go up in the long term, provided the funds are deployed in quality stocks with strong fundamentals.
Here are a few useful techniques that would help you to navigate through the volatile phases of the market.
1. Protecting the portfolio
Hedging is an important part of any bumpy ride in the market. One can hedge a portfolio by buying Nifty Put or Bear Put Spread i.e. using monthly contracts or long-dated options, after understanding the portfolio composition.
The hedging exercise would depend upon the kind of stocks in the portfolio and its beta. For example, in a portfolio with a large-cap Nifty name, it’s easy to arrive at the beta and plan hedging strategy compared with mid and small-cap names.
For a portfolio with mid-cap names, one needs to decide on the right instrument for hedge (Nifty or stocks), the right strike and quantity for spread, and lastly monitoring of the position and exit.
One needs to keep in mind that hedging or mitigating risk does not happen without bearing additional costs and different underlying have different beta. Many a time perfect hedging may not happen but partial hedging also helps to safeguard the existing position.
2. Create short positions in stock futures
In a bear market, selling futures provide an opportunity as many weak stocks go down sharply. It is always advisable to be with the trend till it does not bend. In a weak market trend, the trading short position should be more than taking a long position.
a. Basis a top-down approach, one can find out the weak sectors and stocks to initiate shorting ideas to generate alpha in the market. Stock specific Put buys and bear Put spread can also help to grab the opportunity during a market corrective phase.
b. To select stocks, T is ideal to pick a stock that has a weak structure. A moving average with crossover and the trend line breakdown are some of the technical indicators to identify stocks to short. Another derivative indicator to identify stocks to short can be based on open interest (OI) addition (short built up and long unwinding), higher call writing, and lower put-call ratio stocks.
3. Generating returns through call writing
Call writing is the best and most well-known method that reduces the cost of holding positions and generates extra yield on an existing position.
a. For this, investors need to decide on stocks to do Option/Put writing based on stock-specific liquidity and keeping a margin of safety while writing strikes. The strike price can be based on the buffer and sufficient premium yield. Traders need to monitor the position by putting in certain alerts in the system that will help decide exit or trailing mechanism.
b. Call writing just gives some inflow as a premium but any bigger spike in stock beyond writing strike may not help generate a desirable actual return. It is more suitable for participants who are looking for consistent cost reduction and a certain percentage of profit scenarios.
4. Long & short trades
Pair trading gives an extra edge in such market scenarios as many pairs such as HDFC Bank and HDFC are highly correlated and they provide opportunity when they deviate from their mean. Risk is comparatively low in pair trading, as both stocks have Longs and Short exposure in the market.
5. Trading in option strategy and option spreads
When the market sentiment is bearish, volatility usually remains high and so is the option premium along with higher market risk.
Option writing is not advised in higher implied volatility (IV) scenarios even if the option premium is high. It is better to go with Butterfly and Iron Condor strategies rather than only Selling out of the money (OTM) Calls and Puts.
Selling or buying a future contract also needs to be hedged with protective Puts and Calls to mitigate the risk. This exercise will help avoid any panic for margin calls.
Traders are advised to settle most of the naked positions intraday and avoid carrying much leverage until India VIX (volatility) do not dip down to comfort zones.
Fundamental analysis is the guide for long-term investment. Similarly, technical analysis is the winning tool for traders to make a profit in this ever-evolving market.
(Chandan Taparia is Vice President, Technical Research, Motilal Oswal Financial Services. Views expressed are personal.)
