It is known to everyone that cigarette smoking is injurious to health. It is harmful and addictive too. Smokers indulge in this dreadful habit despite knowing the irreversible damages it could cause to them. They pollute environment and cause harm to others also – physically and mentally. It is a known fact that passive smoking is more hazardous to human life. This is why many countries banned smoking in public places and created designated areas for smoking known as ‘smoking zones.’ This is primarily to protect environment and human life from the ill-effects caused by smokers, and at the same time not to deprive smokers of their freedom to enjoy their abhorrent habit. How is this related to trading financial markets? Continue reading. Before plunging into the concept, let me narrate couple of real incidents which, in my opinion, all of us would have encountered.
Incident#1: Just a day before RBI policy event, one of the fellow-traders advised (in WhatsApp) to go Long ATM CE in a stock, betting on its impulsive move up as soon as the RBI decision is announced, based on his expertise in technical analysis. The stock indeed moved up no sooner than RBI decision flashed on the TV screen. But before he could take pride in his glorified prediction about the stock, he lost significant portion of premium he paid to procure the Long Call, which caused the panic-stricken trader to exit the trade at a huge loss. He couldn’t accept this defeat and so resorted to blaming market and Options trade as the place for gambling. He didn’t stop there. He asserted day-trading in stocks/futures is the best way to make money, but has still been struggling to prove his point.
Incident#2: A trader shorted a stock future by close of market hours in anticipation of a big move down the next day. Next day, the stock gapped up by 100+ points and never returned back to its previous day levels till expiry. He borrowed money to settle the score with market, but alas! he lost the borrowed money too. He was ridiculed by his own family for his reckless behavior in money matters. He resorted to tipsters only to taste multiple failed attempts in trades which caused further dent in his financial condition. He was forced to quit trading by his family.
Such instances are common in which traders lose – not just money but confidence in themselves. Confidence is another key ingredient to become successful, which I shall write about later. There may be hundreds of reasons that can be attributed to such ill-conceived-and-executed trades, but there is one reason common in the aforementioned instances which is what is the theme of this article. The common reason is that the traders in the said situation indulged in playing within the smoking zone. Had they played in non-smoking zone, they would have probably exited the trade with profits or at least with very minimal pre-determined losses which would not have hurt them badly. So, what is smoking and non-smoking-zone all about from the perspective of trading? It can be best explained using a real time example. Let me explain the concept using Adani Enterprises.
Adani Enterprises (ADANIENT)
- Key Statistics as on 21/Apr
- Spot = 145.95; 52W High = 160.70
- Futures = 146.60; Basis = 0.7
- PCR = 0.9; Max Pain = 140
- IV = 58.2%; IVR = 54%;
- Current HV = 83.11% (as given in NSE daily report); Calculated HV = 43.36%
- IV and HV has been falling for the last four sessions
- Time to Expiry = 4 days
- 1 SD range for 4 days = 138-154 (smoking-zone)
- 2 SD range for 4 days = 130-162 (extended smoking-zone)
- SD ranges have been arrived at using calculated HV, i.e., 43.36%
In absence of major news or any other events, a stock is expected to move within 1 SD range 68% of the time, and within 2 SD range 95% of the time. Alternatively, we can say the stock breaching 1 SD levels has only 32% probability, i.e., 16% probability on either side. Similarly 2.5% probability on either side at 2 SD levels.
So, Adanient has 68% probability to move within 138-154 range, 16% probability to breach below 138, 16% probability to breach above 154. Similarly it has 95% probability to move within 130-162 range, 2.5% probability to breach below 140, and 2.5% probability to breach above 162.
A wise trader would know, given the randomness of the stock, it is almost impossible to predict in which way the stock would move within these 1 SD and 2 SD ranges from its current level. It may move up and down randomly, and this is why SLs get hit most of the times. These ranges, 1 SD and 2 SD, are calculated using stock’s HV, which is a measure to determine stock’s future behavior with reasonable confidence. Assuming past behavior is repeated over long term, a stock dominates within its volatility range, i.e., 1 SD range 68% of the time, and 2 SD range 95% of the time. The ranges thus being dominated by a stock is what I refer to as ‘smoking zone.’ Anything outside of smoking zone is ‘non-smoking-zone’ where it has less dominance. So, isn’t it wise to play in non-smoking zone rather fighting a force (stock) in its smoking zone, i.e., its area of dominance? I hope you would answer in affirmative.
So, from Adani ent perspective the range 138-154 is the smoking zone. We can say with 68% confidence that Adani ent can move anywhere between 138 and 154. This means it has 16% chance to move below 138, and 16% chance to move above 154. The area below 138 and above 154 is what I would consider as Adani ent’s non-smoking zone. Let’s proceed to formulate the strategy now. But before that let us quickly see how a stock/future trader can take the trade:
- Stock/Future trade can be taken only at CMP with directional bias. They may use technical analysis to form directional opinion – Bullish or Bearish.
- Long trade: Buy at 145.95 for a target above the CMP. Profit only if stock moves up, which has only 33% chance.
- Short trade: Sell at 145.95 for a target below the CMP. Profit only if stock moves down, which has only 33% chance.
- As stock dominates within its smoking-zone, probability of losing in these trades is very high (68-75%). This is because the entry level and SL are within the range where the stock dominates, i.e., within its smoking zone.
Let’s proceed with discussing high probability trades using options strategies.
- Quick Inferences from the Key Statistics
- Adani ent’s smoking-zone = 138-154 is established. (Note: We will never face the enemies in their area of dominance in order to augment our winning chance. This facility is not available for stock/future traders).
- Adani ent has IVR > 50 and has only 4 days to expiry. Both justify we should go for net short strategies.
- IV and HV are deteriorating over the last 4 sessions, which indicates traders’ diminishing interest. Stock is also becoming less volatile (or probably in consolidation mode).
- Earnings event was over on 14/Feb, so stock making very high moves within this expiry looks bleak;
- Uncertainty and indecision prevails as the stock is trading in very narrow range for the last three sessions (Doji for the last three days)
- Option Strategy – Credit Call Spread or Credit Put Spread
- Credit means receiving money in our account, which can happen only by shorting options.
- Spread means taking the trade using two different strikes.
- Call Credit Spread means, a credit strategy using two different strikes of CE, and which has high probability of success/profit (or low probability of failure/loss).
- Put Credit Spread means, a credit strategy using two different strikes of PE, and which has high probability of success/profit (or low probability of failure/loss).
- By now, we know taking trades in non-smoking zones helps securing high probability of success.
- Credit Call Spread
- Adani ent’s smoking zone is 138-154, which is its 1 SD level. So, the call strikes will need to be above 154 as the trade has to be taken in non-smoking zone.
- 155 CE is the first strike in non-smoking zone. Its delta of 0.18 also confirms 155 CE has only 18% chance to expire ITM in 4 days. In other words, 155 CE has 82% chance of expiring OTM. So, shorting 155 CE guarantees 82% chance of making profits. However, risk is unlimited if trade goes against our favor, i.e., when stock breaches our short strike level on the upper side. This means losses are unlimited, although there is less chance to make losses. That is where strategies help as risk and reward can be predetermined.
- Credit Call Spread is executed by shorting a strike and buying a strike at higher level. This is a two-legged strategy.
- So, Short 155 CE @ 1.30, and Long 160 CE @ 0.70 forms Call Credit Spread. Here we receive 1.30 in our account by shorting 155 CE, and spend 0.70 to buy 160 CE. So, the total credit is 1.30 – 0.70 = 0.60.
- Max profit = 4800; Max loss = 35,200 (Don’t be afraid of seeing the loss figure. Continue reading.)
- Profit of 4800 is made when spot <= 155. Probability of making profit is 82%
- Max loss is made when spot > 155. Probability of making loss is 18%
- Since Probability of Profit > Probability of Loss, and Probability of Loss < 15%, this trade is worth taking at 1 SD level. Take the trade at 2 SD level if you are concerned about the huge loss of 35,200.
- 2 SD upper level = 162. So, Short 160 CE @ 0.70 and Long 170 CE @ 0.3, for a total credit of 0.4, which is 3200 rupees. In fact we can take risk by just shorting 170 CE for a credit of 5600 as 170 CE has a delta of 0.1, i.e., has only 10% chance to expire ITM by expiry, i.e., in the next 4 days. This means the trade has 90% chance to be successful.
- Whether the trade is taken beyond 1 SD or 2 SD ranges, the trade has high probability of making profits, i.e., >= 85% of chance to make profits.
- Another key point to note is that Adani ent can move anywhere, up or down, from its CMP. It is not going to affect our profit potential as long as it remains below our short strikes of 155 CE or 160 CE, as the case may be. This means we give room for the trade to go against our favor and still make profits. A win-win situation.
- Credit Call Spread is a bearish strategy. But stock turning bullish will not hurt our profit potential as long as it remains within its smoking zone i.e., 1 SD/2 SD ranges. Remember we have taken the trade in non-smoking zone. This means we still make profits despite being wrong in our directional bias. This is not the case with stock/future traders. They have to be 100% correct in their directional bias.
- Similarly Credit Put Spread can be deployed to make similar profit levels (try it yourself).
Let’s conclude with some key take-always:
- Playing in smoking zone gives only 33% chance to win, while playing in non-smoking zone gives >= 85% chance to make profits.
- In other words, playing within smoking zone has 67-75% chance for making losses (which is unknown and unlimited), while playing in non-smoking zone has only 15% chance for making losses, which can be pre-determined.
- Pre-determined profits and losses help us decide taking the trade (only available for options players)
- Playing in non-smoking zone allows us make profits despite being wrong in our views.
- The distance that a stock has to travel from its current level to prove us wrong is far off, hence the trade going against our favor has very low probability. This means we have sufficient time to adjust our trade in case of the trade going against our favor. Stock/Futures traders do not have such facility as even a 5 paisa move against their favor will start producing losses. (Note: Adjustments to strategies is a different topic and has to be well understood before attempting)
- Options Strategies can be applied for any market situation. The one used here is to demonstrate a way to making profits using high-win and low-risk probability strategy.
- Option Strategies, when applied correctly; help to make consistent profits and better ROI – without TENSION.
I hope to have provided few pointers for you to decide if you want to be trading in smoking zone or non-smoking zone, i.e., if you want to be a smoker with low probability of making profits or a non-smoker with high probability of making profits. This article is for educational purposes and to illustrate the concept, and hence is not a recommendation in anyway. Readers are encouraged to imbibe and practice the concept/strategy before taking real trades.32