Mastering Derivatives: Gaining from price consolidation

Previously in this column, we discussed how to choose between a short call and a short put position. This week, in response to a reader query, we discuss when to setup a short option position based on chart patterns.

Consolidation phase

An underlying is said to be trending up when its price forms higher highs and higher lows. Note that even when the underlying is trending up, bears may be temporarily in control. This is because bulls may run out of resources to continually push the price up. An underlying is said to be trending down when its price forms lower highs and lower lows.

Take the case of an underlying price trending up. The first sign of a bull exhaustion is when the price forms a lower high. You can draw a resistance line touching the highest point of the current uptrend. It is also likely that the underlying will then begin to move within a tight range. This is a signal that bulls and bears are fighting to gain control after the current uptrend. The underlying is then said to be in a state of consolidation. That is when setting up a short position becomes optimal.

Note that your objective is to gain from time decay when you short a call or a put option. Typically, if your view is that the underlying is likely to move sideways, it is preferable to short an at-the-money (ATM) option. This is because an ATM option has the highest time decay. If you are biased towards the price marginally moving in one direction compared with the other, then, perhaps, an ITM option may be preferable. For instance, you may believe from your reading of the price chart that bears have a marginal edge over bulls. Then, you may consider shorting ITM calls to gain from the decline in option delta in addition to time decay. That is, an ITM call will lose some of its intrinsic value if the underlying declines.

Finally, your choice between shorting a call and shorting a put depends on the location of the underlying price in relation to its resistance and support level in the consolidation phase. If the price is close to the resistance level and bulls are still struggling to break above the level, shorting a call may be gainful. If the price is close to the support level and yet the bears are struggling to push the price below this level, shorting a put may be better.

When to go for ITM

If you are biased towards the price marginally moving in one direction compared with the other, then, perhaps, an ITM option may be preferable

Optional reading

Shorting options is a negatively-skewed strategy. That is, the strategy is likely to generate small frequent gains but likely to suffer large infrequent losses. You must manage your short positions with strict stop-loss levels. Your stop-loss for short calls must be based on the underlying moving just above its resistance level; for short puts the stop-loss must be based on the underlying moving just below its support level.

The author offers training programmes for individuals to manage their personal investments

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