Top F&O Strategies for Profitable Investments

Top F&O Strategies for Profitable Investments

Last Updated: 2019-11-12T04:30:00+05:30

Warren Buffett once described derivatives as weapons of mass destruction. That is largely because derivatives have either been misused or used without proper understanding. As an investor, you can go beyond just futures trading to also include some very profitable options strategies. These options strategies can be used not only to enhance your profits but also reduce costs. They can work both ways. Let us look at some interesting ways to use F&O strategies for profitable investing. In fact, most online trading platforms offer F&O strategies as part of their offerings and use such hybrids accordingly.

Protective puts to enhance profits on the downside

Assume that you are holding on to a stock like Reliance Industries that has been extremely volatile in the last few months. However, you are still convinced about the long term prospects of the stock and want to hold on. You can use protective puts to behave like a dual wealth enhancer. Here is how. Suppose you bought RIL at Rs.1600, then you can hedge it with an Rs.1580 put option at a premium of Rs.20. Thus, your maximum loss will be Rs.40; irrespective of how low the stock dips. That is a passive protection. The second aspect is the active profiting from such a strategy. Each time the stock corrects, you can book profits on the put option and add on to your investible surplus. It thus works as a dual benefit.

Covered calls to reduce your cost of holding

Profitable investment is not just about enhancing returns but also about reducing your cost of holding. That is what covered calls are all about. In a covered call, you sell a higher strike call option while holding the stock. This strategy is typically applied when you purchase a stock for the long term; but the price corrects. The short term resistance can be the level to sell a call option. Each month as the call expires worthless you earn the premiums and reduce your cost of holding. In a worst case scenario if the price of the stock moves up, you lose money on the call you have sold but there is no risk since you already have the stock on hand. This strategy works very well when it comes to reducing the cost of holding instead of just letting your stock idle in the demat account.

Tapping the reverse arbitrage opportunity

This can be slightly more complicated than buying and selling futures. Arbitrage in F&O means buying a stock and selling equivalent futures. The spread between the two is the assured profit because on the expiry date, the cash and futures position will expire at the same price. In a reverse arbitrage you sell the stock and buy the futures of similar quantity. But how is that possible? You can only do that against your holdings. Assume that you are holding shares of ACC for over 2 years and the futures go into deep discount without dividend impact. In that case you sell the stock and buy the futures. Here is the advantage. Firstly, you get the benefit of the discount as a riskless profit. Secondly, you convert your cash into futures; so you hold same quantity with much lower margin. Finally, since you have already held the stock for more than a year, it is LTCG and tax will not be an issue. That is how to profit from reverse arbitrage. But reverse arbitrage is not too frequent.

Play the volatility with strangles

Most of us are comfortable trading or investing when the direction of the market is clear. When it is bullish you buy and when it is bearish you sell. What do you do when the markets do not exhibit any specific direction? Assume you have an equity portfolio and you expect the markets to be volatile due to macro factors. However, you are not clear about the direction. You can buy strangles on the Nifty; meaning buy a call of higher strike and put of a lower strike. Your loss is limited to the premium paid but profits on either side are unlimited. Also, since it is a long/short strategy, it does not change the nature of your overall exposure. This can be applied with limited loss.

F&O strategies can be used to enhance profits or reduce costs. They can really work well if used appropriately and with due care.

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