Derivatives
LONG FENCE
Alex K. Mathews, Research Head, Geojit Financial Services
This is one of the most admired derivatives Index Strategy in an oversold market. If the market short term oscillators are in the oversold territory and a potential reversal on Index is expected, then one can apply this strategy. A long fence can be created by simply buying the Nifty futures with Nifty put options along with a written call option slightly higher than the Nifty put strike prices. Traditional players normally choose the same strike price for buying put option of Nifty and selling Nifty call.
But there are professionals who buy the Nifty futures along with an in-the-money put option and will choose to write the Nifty call slightly higher, probably a strike price close to the nearest Nifty resistance level.
As the market is in the oversold territory, we can expect a reversal on Nifty and profit from Nifty long futures. Your loss would not be substantial even if the above stated situation does not materialize as the long Nifty put options will give you downward protection. The cash outflow can be reduced by selling the call option.
The beauty of this strategy is the low risk, limited profit and low margins. If an investor buys only a call option with high implied volatility in an oversold market, he may lose the investment even if the Nifty is on an upmove because call premium will come down due to decreased implied volatility. Theory says in an oversold market, option premium will tend to remain high but will decrease if there is a reversal.
An investor who wants to buy a Nifty future alone in an oversold market is taking a 100 percent risk. But a combination of long Nifty future along with the Nifty put will reduce the risk by 100 percent.
Let us take an example. An investor buys Nifty futures at Rs 3050 and also buys a Nifty put option of Rs 3050 at a premium of Rs 120. Simultaneously, the investor sells a call option slightly higher than the Nifty futures level, say Rs 3500, at a premium of Rs 40. The expiry date is assumed to be the same for the entire trading strategy and the lot size would be 100.
The investor here may lose a maximum of Rs 8000 only if the Nifty closes at 3050. Maximum profit for this strategy is Rs 37000.