Mastering Derivatives: Using option gains to initiate long underlying?

It is not uncommon for traders to take profits on an underlying position and use some of the gains to initiate a long call position. This would be meaningful when traders continue to have a bullish view and yet want to lock in to their gains on the underlying. But is a reverse strategy meaningful — taking profits on long option positions and using the gains to initiate a position in the underlying? This week, we discuss whether moving from options to the spot market is optimal.

Options to spot

Suppose you have a bearish view on an underlying and initiate long put position on an immediate out-of-the-money (OTM) strike. Several sessions later, the underlying declines and your OTM strike becomes in-the-money (ITM). Given that you are trading European options, you must close your position if you want to take profits before option expiry. And that means selling the long put before liquidity in the strike declines. If you continue to believe that the underlying is bearish, initiating a long position on a current immediate OTM strike would be meaningful.

But what if you believe that the underlying has bottomed out? That is, you believe that the bears are exhausted. You could initiate a long call position to bet on your view. But if are bottom fishing (value buying), then buying the underlying would be meaningful. This is because bottom fishing trades may not gain momentum for a while. And that means initiating a long call option will not be worthwhile as the position could lose from time decay, if not expire worthless. An added benefit would be when the underlying is trading cum-dividend. Note that a long call or a long futures position will not entitle you to dividends on the underlying unless the expiry is before the record date set for the dividends.

Note that options cost a fraction of the underlying price. So, using some of the gains that you make in the spot market to buy calls is possible. But is it possible to use some gains from options position to buy the underlying? Not unless you are trading multiple put option contracts on the underlying and the gains are significant. Otherwise, you may have to utilise the entire sale proceeds from puts to buy the underlying.  

So, why would a trader consider such a strategy? Every trader has affinity to certain stocks. Bottom fishing such stocks becomes a compelling desire, even if the trading portfolio otherwise consists of momentum bets. That is when the above-mentioned strategy could be applied.

Take note

Bottom fishing is not typical trading strategy because your trading capital could be locked up for a while before a stock gathers momentum

Optional reading

Bottom fishing is not typical trading strategy because your trading capital could be locked up for a while before a stock gathers momentum. The only consolation in the above-mentioned strategy is that you have used some gains to fund the trade, and not your entire initial capital. This strategy also applies to closing short futures position and initiating a long position on an underlying.

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