Strategies To Be Adopted In Range-Bound Markets

Different market conditions call for different market-beating strategies. Karan Bhojwani explains various strategies that can be deployed in a range-bound market even as the DSIJ Team analyses the market performance on a YTD basis. 

The year 2018 so far has been difficult for the markets as there seems to be no clear trend emerging since the beginning of the year. Volatility has increased for global equity markets in 2018 and the investors favourite mid-caps and small-caps have taken a huge beating. The conundrum facing the longterm investors is that in spite of the recent fall in mid-caps and small-caps, the valuations are still looking rich for several stocks and hence the current set-up is providing only limited investment opportunity in the markets. 

India has underperformed on YTD basis in 2018 compared to its global peers. 

Where are FIIs investing? 

FIIs along with the DIIs are dominant players in the Indian markets. For investors it is always useful to know where are FIIs investing. FIIs are seen overweight on financials, along with the IT and auto sectors. Almost 39 per cent of free float of the market in India is owned by the FIIs. The FIIs are seen selling Indian securities and, overall, the money withdrawn from the markets in CY18 so far is much higher than any comparable period since 2001. (Refer table below). This heavy selling by the FIIs in both debt and equity markets is also one of the reasons behind the weakening of rupee against the US dollar 

FIIs as a group have been bullish on Indian equities ever since they were allowed to first invest in India. The net investment into Indian equities has been on the rise since 2001. Here are the stocks where FIIs holding is above average
 

Pankaj Karde 
Head- Institution Sales & Sales Trading, Systematix Shares & Stocks 

❝Growth potential with good valuation is the key to value picking at this point of time❞ 

After sharp correction in mid-caps and small-caps, do you think the valuations have become attractive? 

The sharp correction in mid-cap and small cap stocks has made some fundamentally strong stocks attractive. The clean-up in the segment is happening and, in that case, many stocks would be attractive on the valuation front. But not all stocks should be bought. The growth potential with good valuation is the key to value picking at this point of time. 

Do you believe markets will be rangebound hereon due to lack of trigger? How to trade/invest in such market environment? 

I believe that the market would be volatile, but range-bound. Nifty should hover around 10400 -10700 levels. Any break of levels on either side can see Nifty gaining momentum In such a market, it is best to create cash levels for future investments. Also, as mentioned above, selective buying in large-caps should be done. Many investors would be still holding on to the mid-cap stocks. An introspection of the current holdings is essential. News-driven stocks would find it hard to come back to previous levels and hence exiting those stocks is a good decision. At the same time, stocks which are fundamentally good and have consistent growth visibility should be bought. These stocks would have corrected to make them attractive on valuation. We cannot time the market, hence a valuation call needs to be taken. 

Should one bet on large-caps at this juncture? 

One should start looking to invest selectively in large-caps as the exposure in mid-caps has reduced. I recommend to have at least 20% cash for investments in mid-cap and small-cap companies in the immediate future 

Volatile relation between crude oil prices and Sensex: 

While most investors would bet that the rising crude oil prices is negative for stocks prices in India, we find that there is good amount of negative correlation displayed by both the asset classes, but not always. There are times when the economy is growing at a rapid pace and, with the economic growth, there is rapid increase in demand for crude oil, which pushes the crude oil prices upwards. We see that crude oil and Sensex are correlated in terms of volatility and hence it is difficult to say that rising crude oil prices is always negative for the equity markets. The data below suggest that there are several instances where the markets have inched up despite rapid increase in crude oil prices. At the same time, we see that there are several instances where the crude oil prices have dipped and yet the stock prices have not inched up. 

❝As an investor one should understand that there is a lag between crude oil prices and reported earnings by companies due to their operating cycle. For example, a company buying crude oil today will convert it into finished product six months later and report the earnings maybe nine months thereafter. Sensex will be affected by the earning rather than by the crude oil price nine months later. ❞ 

Option trading strategies for the range-bound market 

1. Iron Condor Spread
Iron Condor Spread Trading Strategy : 

An iron condor spread strategy is a four-legged trade, consisting of two puts and two calls, and four strike prices for the same underlying security having same expiration date. It is important to understand that the iron condor strategy is a limited risk strategy and profits come from the passage of time or decreases in implied volatility, as long as the stock price remains between the two break even prices of the position. 

Setting up An Iron Condor Spread Strategy : 

The iron condor spread has four legs, meaning you need to place four orders with your broker. A combination of puts and calls are involved, and you need to both buy and write (sell) options. The four trades than need to be executed are as follows: 

• Buy out-of-the-money call option
• Sell out-of-the-money call option (lower strike than above)   
• Buy out-of-the-money put  
• Sell out-of-the-money put (higher strike than above) 

The number of lots bought or sold in each of the legs should be the same, as also the expiration dates used should be the same The two short legs should use strikes that are equidistant from the current trading price of the underlying security, as should the two long legs. However, it is upon the trader to decide exactly which strikes to initiate.

Hypothetical case of iron condor spread: 

Here is a hypothetical case of an iron condor spread to give you an idea of how it can be used. We have taken hypothetical option prices in the example to make it easier to understand, rather than taking the real market data. Also, we have ignored brokerages and commission that would be involved in the transactions. 

Let us assume that XYZ Company's stock price is Rs 500 when entering the position and a trader expects the price of the stock price will stay relatively close to that price. The lot size of the contract is 1000. 

• You will buy 1 contract (Rs 1.94) of out-of-the-money call (Strike 600). This would be Leg A. 
• You write (sell) 1 contract (Rs 7.89) of out of-the-money call (Strike 550). This would be Leg B. Important point to note that when we write or sell option, we receive credit. 
• You buy 1 contract (Rs 0.72) of out-of-the-money put (Strike 400). This would be Leg C. 
• You write (sell) 1 contract (Rs 6.15) of out-of-the-money put (Strike 450). This would be Leg D.

In the above example, The total credit received from short options: 

Rs 6.15 (Strike 450 Put) + Rs 7.89 (Strike 550 Call) = Rs 14.04 (Step 1) 

Debit Paid for Long Options: 

Rs 0.72 (Strike 400 Put) + Rs 1.94 (Strike 600 Call) = Rs 2.66 (Step 2) 

Total Credit Received: 

Rs 14.04 (Step 1) – Rs 2.66 (Step 2) = Rs 11.38 

Maximum profit from Iron condor spread: 

The iron condor spread will generate the maximum possible return when the underlying security settles between the short strikes of trade at the expiration. Maximum profit achieved would be the net credit received multiplied by the lot size of the contract. In the above example, it would be Rs 11.38 (total credit received) * 1000 (Lot Size) = Rs 11,380.

Calculation of break-even of this strategy: 

In this strategy, there are two break-event points, one is the upside break-even point and the other is the lower break-even point. 

Upside: Short Call Strike Leg B (550) + total credit received (11.38) = Rs 561.38
Lower: Short Put Strike Leg D (450) – total credit received (11.38) = 438.62 

Theoretical risk for this strategy : 

Regarding loss potential, the maximum potential you can lose is the difference in the strike price between long and short strikes, minus the net credit received. In the above example, the difference in the strike price between long and short strikes is 50, i.e. Leg A Strike Price (600) – Leg B Strike Price (550) less the net credit received (11.38) * lot size (1000). The maximum potential loss is 50 (difference in strike price of one of the spreads) - Rs 11.38 (net credit received) * 1000 (lot size) = Rs 38,620. 

Important points to remember : 

When you initiate this strategy, it is important to check implied volatility, as the ideal environment to initiate this strategy is when implied volatility is high. When initiating iron condor, a trader’s best friends are the passage of time and decrease in implied volatility. To be profitable in iron condor spread strategy, big stock price movements or increase in implied volatility must not occur within a short period of time. 

2. Short Strangle
Short Strangle Trading Strategy : 

A short strangle is a straight forward strategy of writing call options on the relevant underlying security, while writing an equal amount of put on the same security having the same expiration date. A trader would use short strangle when he/she has a neutral outlook on the underlying security, i.e., you think underlying will stay within a tight trading range.This is a two-legged strategy consisting of writing (selling) both call and put options. 

Setting up a Short Strangle Strategy : 

The short strangle has two legs, which means you need to place two orders with your broker. A combination of put and call is involved, and you need to write (sell) both the options. The two trades that are required to be executed are as follows: Sell out-of-the-money call option Sell out-of-the money put option 

Hypothetical case of the strategy: 

Here is a hypothetical case of a short strangle to give you an idea of how it can be used. We should point out that we have used simplified, hypothetical option prices in the example, rather than using the real market data. Also, we have not taken into consideration brokerages and commission that would be involved. 

Let us assume that ABC Company's stock price is trading at Rs 200, and you as a trader expect that the price of the stock price will stay close to Rs 200. The lot size of the contract is 1000. 

1. You will write (sell) out-of-the-money call option of (strike 210) trading at Rs 4.31. This would be Leg A. 

2. You will write (sell) out-of-the-money put contract of (strike 190) trading at Rs 3.78. This would be Leg B. 

The short strangle has been created for a net credit of Rs 4.31 (Leg A) + 3.78 (Leg B) = 8.09 and, in terms of total premium received, Rs 8.09 (net credit) * 1000 (lot size) = Rs 8,090

Maximum profit from Short Strangle : 

The maximum profit a trader can make using short strangle is limited to the amount of the upfront net credit, which is Rs 8090 in the above example. A trader would make the maximum profit if the underlying security was trading between the two strikes i.e. 190 to 210. Both the 190 put and 210 call expire worthless, leaving short strangle trader with the maximum profit. 

Calculation of break-even of this strategy : 

In this strategy, there are two break-event points: one is the upside break-even point and the other is the lower break-even point. 

Upside: Short Call Strike Leg A (210) + Credit Received (8.09) = Rs 218.09
Lower: Short Put Strike Leg B (190) – Credit received (8.09) = Rs 181.91 

Risk involved: The short strangle is an undefined risk option strategy. Since an underlying security price can rise indefinitely, a short strangle has unlimited loss potential, in theory.

Important point to remember: 

To be profitable when selling strangles, large stock price movements or increase in implied volatility must not occur in short periods of time. 

Conclusion:- 

Owing to lack of a secular trend in the market, it is challenging for momentum traders to make money in the current market scenario. For long term investors, the focus should continue to be on the quality of earnings and the growth reflected in the earnings. A disciplined approach towards investing is the need of the hour and one must hold some amount of cash in hand in times like these, where the market is expected to trade in a range-bound manner. There will be opportunities created in the markets sooner or later. As an investor, one must be ready with the list of stocks to buy when the opportunity presents itself. 

A bottom-up investing approach will be required as opportunities exist across market capitalisation. We expect the markets to remain range-bound and any investment strategy that bets on a particular direction of the markets may not fetch the desired results.Investors can expect markets to remain in rangebound till october this year after which it may take a firm direction. 

Foram Parekh
Fundamental Analyst – Equity, Indiabulls Ventures Ltd. 

❝This is a stock-pickers' market❞ 

Are valuations in mid-caps looking attractive yet? 

The valuations of the mid-cap index is certainly trading higher than the large caps. But the mid-cap index has corrected significantly from its peak five months ago and, as a result, the Nifty mid-cap index valuation has fallen from 99x FY18 PE to 54x FY18 PE. However, the index is currently trading at a decent valuation, which is higher than the ideal valuation. There are many stocks in the mid-cap universe which are still trading at attractive valuations, indicating scope for growth. For example, when the entire mid-cap index is trading at rich valuations, there is still a stock called GNFC which is trading at a mere 8x FY19 PE despite the good run in the stock in particular and the index as a whole. 

It has become a stock pickers' market, rather than an indexdriven market due to the improved earnings of many mid-cap companies. If the earnings are good supported by good demand for their product, the stock can outperform the index in the long run. The current correction in mid-caps has given a good entry point to the new investors who had missed the earlier opportunity of gaining quick multi-bagger returns from the mid-cap space.

What is the probability that mid-caps and small-caps will do better than large-caps in coming quarters? 

There is very high probability that the mid-cap index will do better than the large-cap index in the upcoming quarter as mid-caps and small-caps have the tendency of giving exponential returns. The large-cap index, on the other hand, does not have the tendency to deliver exponential returns as they are mostly index stocks. If mid-caps perform well, these have an opportunity to become large-caps. Hence, there is always room for multi-bagger returns in the mid-cap stocks. Similarly, if a small-cap company continues to deliver good set of earnings, it will always have room for turning into a mid-cap and eventually a large-cap company. For instance, the stocks of Yes Bank and Aurobindo Pharma continued to perform good right from the time they were known as mid-cap stocks and these eventually grew to become large-caps. Both are now called as index stocks. Hence, there is always a higher probability of mid-cap and small-cap stocks outperforming the large-cap stocks in the coming quarters as well as in the coming years. 

Are mid-caps and small-caps in bearish territory? 

The mid-caps and small-caps are not in the bearish territory, but these were definitely due for correction. Since the mid-cap and small-cap indices were rallying since the time of Narendra Modi’s assumption of office as PM, these were ripe for correction. The chance of making quick returns is definitely over, but having said that, there is still room for opportunities for mid-cap and small-cap indices to outperform the large-cap index. As correction is healthy, any good correction always leads to a good rally, and with fundamentals supporting the company’s earnings, mid-caps and small-caps will continue to rally, albeit at a slower pace. Though the correction might not be as steep as we witnessed earlier, but during unfavourable global conditions, mid-caps can correct probably at the most by 5-10%. Hence, although mid-caps and small-caps might see mild corrections in the near future, they are certainly not in the bearish territory