Consolidation: Time to Short or Long?

Things you need to know while trading in Options

Consolidation is a very interesting time in any index or stock. Shorter the consolidation, generally, lesser is the volatility post that and vice versa. It’s like the more you press a spring, higher it bounces. Similarly, is volatility stays subdued for a long time, it comes back hard and fast.

In the cash and futures and world it’s simple, you are either long or short and according to the stock movement post the consolidation, one either reaches the target or hits the stop loss. But in case of options it is slightly different. One can be long or short the stock and the option also. There are some traders who by design are option sellers. They generally look out for stocks or indices which are range bound and keep writing options around those levels. But this comes with a risk of a volatility blow out. If it breaks above or below a particular zone stop losses get triggered. This further inflates the move.

As for the directional player they constantly wait at those blow out zones and once in a while they hit their jackpot. It is clearly a tussle of timing vs risk management. Timing for option buyers and risk management for option sellers. But, this tussle leads to some mistakes by both the participants at times and one can look to benefit from it also.

I would like to share a recent instance around this. Auto stocks till last month had been reeling under significant pressure. Though they have done significantly well this month, especially Tata Motors. The case in discussion here is that of Ashok Leyland. The stock had been consolidating in the range of 85-90 since Feb end to March end. A few blips above 90 but largely the stock was in the range of 85-90.

This time around however, the stock witnessed maximum Call build up at 95 levels. This indicated that the blip above 90 was in offing. Call writers are comfortable at higher zone for shorting then the usual range levels. However, the 90 Calls were also constantly adding positions. This was slightly adventurous. On 5th April while the stock continued to stay below 90 at 87 levels. The total build up at 90 Call was 56.6 lakh shares and at 95 Call was 71.6 lakh shares. An addition of 35 lakh shares within three days in 90 Calls was a decent set up.

The trade idea was clear, 90 may break trigger quick short covering and 95 resistance might hold. So, I had my levels clear in my head. I bought Ashok Leyland April 90 – 95 Bull spread at close to Inr 1 the next session.

The stock closed flat. Next day it give the first blip above 90 levels. However, by the end of the week 90 Call writers had capitulated. There was a covering of nearly 35 lakh shares, the stock price was at near 96 and the spread was worth around Inr 3.5/-.

While OTM call addition was a trade signal and additional confirmation of a possible Short Covering strengthened my conviction and give me a clear direction of the trade and strategy.

Net-net timing and risk management are the two most crucial essence of your option trades.

Happy Trading.

Cheers!!!