Stock market volatility: 5 F&O strategies that can help traders make the most of volatility

Rising and falling are an integral part of investing in the stock market.

Each phase of the market has its particularity and an appropriate approach is necessary, with the right frame of mind, to limit losses or maximize gains, as the case may be.

Most often, investors fall into illusions and try with a long period of correction and stagnation, leading to negative portfolio values. Contrary to investor expectations, gains are never linear and are mostly lumpy.

Most equity investors only buy in and don’t have a plan to protect the portfolio against potential market fluctuations, resulting in subpar performance.

An investor should remember this and do some basic research because much of the movement in stock prices only occurs within a few trading sessions. The solution to this is to be a patient investor as stocks always go up over the long term, provided the funds are deployed in quality stocks with strong fundamentals.

Here are some useful techniques that will help you navigate through volatile market phases.

1. Protect the wallet
Coverage 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 term options, after understanding the composition of the portfolio.

The hedging exercise would depend on the type of stock in the portfolio and its beta. For example, in a portfolio with a large cap name Nifty, it is easy to arrive at beta and plan a hedging strategy against mid and small cap names.

For a portfolio with mid-cap stocks, one must decide on the right hedging instrument (Nifty or stocks), the right strike and the right amount for the spread, and finally the position monitoring and the exit.

It should be kept in mind that hedging or mitigating risks does not come without incurring additional costs and that different underlyings have different betas. Often, perfect coverage may not occur, but partial coverage also helps protect the existing position.

2. Create short positions on stock futures
In a bear market, selling futures offers an opportunity as many weak stocks fall sharply. It is always advisable to be with the trend until it does not fold. In a weak market trend, trading the short position should be more than taking a long position.

a. Based on a top-down approach, one can uncover weak sectors and stocks to initiate short selling ideas to generate alpha in the market. Stock-specific put buys and the bearish put spread can also help seize the opportunity during a market correction phase.

b. For selecting stocks, T is ideal for choosing a stock that has a weak structure. A moving average with crossover and trendline breakdown are some of the technical indicators to identify stocks to sell. Another derivative indicator to identify stocks to sell can be based on the addition of open interest (OI) (short built and long unwind), higher call write and lower put-call ratio stocks.

3. Generate Feedback Through Writing Appeals
Writing calls is the best and well-known method that reduces the cost of holding positions and generates additional return on an existing position.

a. For this, investors need to decide which stocks to issue as options/puts based on stock-specific liquidity and keeping a margin of safety when writing strikes. The strike price may be based on the buffer and a sufficient premium yield. Traders should monitor the position by placing certain alerts in the system that will help decide on the exit or follow-up mechanism.

b. The write call only gives some inflow as a bonus, but any larger stock spike beyond the write strike may not help generate a desirable real return. It is best suited for participants who are looking for a constant reduction in costs and a certain percentage of profit scenarios.

4. Long and short trades
Pair trading gives an added edge in such market scenarios as many pairs such as HDFC Bank and HDFC are highly correlated and offer opportunities when they deviate from their average. The risk is relatively low in pair trading, as both stocks have long and short exposure in the market.

5. Trading options strategies and option spreads
When market sentiment is bearish, volatility generally remains high, as does the option premium as well as 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 opt for the Butterfly and Iron Condor strategies than to only sell calls and put options out of the money (OTM).

The sale or purchase of a futures contract should also be covered by protective puts and calls to mitigate risk. This exercise will prevent any panic for margin calls.

Traders are advised to settle most naked positions intraday and avoid high leverage until the Indian VIX (volatility) does not dip into comfort zones.

Fundamental analysis is the guide to long-term investing. Likewise, technical analysis is the winning tool for traders to make a profit in this ever-changing market.

(Chandan Taparia is Vice President, Technical Research, Motilal Oswal Financial Services. Opinions expressed are personal.)

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