An alternate approach to trading breakouts through option selling
Breakouts happen all the time and there are many ways to trade breakouts like buying equity or future, selling put or put spread, buying call or call spread. Every trader has their own approach. Usually when stocks are breaking out or are trading higher, the calls are in demand resulting in a skew on the call side (also known as reverse skew). In order to take advantage of rise in IVs and call side skew, the way I trade this is by shorting a bullish bias strangle. The trade can be intraday or positional based on one’s personal comfort. How to identify the breakout, I will leave it for you to decide; It could be anything — ATH/52-week high, NR4/NR7 breakout, 20D breakout, breaking out of an important resistance level but what’s important to understand that this method is suitable only if there is good IV expansion. And when that happens, buying a call or a call spread is not advisable as even if the stock moves further up, it might be accompanied by IV crush and the call (or call spread) might not make money despite stock moving up. The beauty of this method is that even if you are late in identifying a breakout, you can still get in if there is sufficient IVs left to trade.
Let’s consider some examples to better understand.
DLF — DLF is in a clear uptrend based on daily chart. It has attempted to fill the first gap created during March fall on 19th Nov but met with a huge supply. This time around, it closes above that 200–202 level on 2nd Dec and it’s a clean breakout on charts.
Now check the IV charts on 3rd/4th Dec — On each of the two days i.e. 3rd and 4th Dec, it opens with IV spike and IVs starts to slide down. Once IVs are met with spurt but don’t get a follow-through and tend to decline, that’s where one can put a vol short trade.
Since we have already established our bullish bias, one can short ATM-1 put and ATM + 3/4 call.
Check the chart of 190/230 strangle and how they behaved on each of the two days. After it opens with a gap up due to IV spurt, the strangle price continues to slide.
Ex — 2 Bharti Airtel — 480/500 has proven to be the resistance zone for Bharti a few times and on Friday, it was again trying to cross this hurdle of 480–500 zone. So, assuming that it will cross this hurdle, one can initiate a bullish strangle.
Now check the IV chart and the strangle chart of Bharti — Much like DLF, on both the days, IVs opened up higher and then started to slide. As the IVs start going down, one can initiate the trade in 480/540 strangle. The strangles continued to lose value as the stock moves higher.
Ex-3 Tata Chemical — Looking at the chart, it’s a no brainer that the stock is trading with strong bullish bias.
Let’s consider Friday (4th Dec) where it continued to go higher throughout the day and how the trade would have fared.
First the IV chart — As usual, IVs open higher and tend to slide. Stock is trading at 455 so one can initiate 440/490 strikes. Let’s check the chart of this strangle.
Assuming one gets in and out at the worst possible time and some slippage, this strangle would have lost 6 bucks or 12k without any adjustments in the trade. This is because the stock saw an 8% intraday rise and post 2.30 PM, IV spike kicks in again as the stock continues to go higher. But remember we are trading for stocks breakout so at all times we must continue our deltas to be positive. So, as soon as the trade is going towards being delta neutral (that’s when the trade must already be making money), roll the put one strike up and make the delta positive again. Obviously, if the stock moves relentlessly, the trade will eventually be a loser and one must accept losses. Remember not every trade makes money. A good trader must accept losses humbly. One can argue that I was playing for a breakout and yet got out at a loss despite the massive breakout, then what’s the point? The point is to take advantage of rising IVs/ skew on the call side. Not all breakouts are successful ones, some fail and some are slow. This method would result in profits in those cases. Most of the time, the trade makes money with or without adjustments but loses money in two cases — one when the rise is very strong and stock makes say 10%+ rise intraday with great momentum and two when there is a lot of zig-zag movement and adjustment costs kick in.
1. As always, any setup is just that — setup. Trade management, position size and risk management are far more important than any setup. So, one should pay equal focus there if not more.
2. Do not try to short the rising IVs on the first sign. Wait for either stock to settle down or the IVs to start sliding down.
3. If trading multiple lots, start with 25–50% (depending on capital/lots to trade), add more only when trade starts to go in your favor. If the trade is not going in your favor, don’t add.
4. If instead of our anticipated up move, stock tends to slide down, roll the call down just like we have to roll the puts up if the stock movement is very fast on the upside. Remember we have to keep delta in check and keep adjusting the trade.
5. A few times, there will be a zig-zag movement and your adjustments will cost you. Remember not every trade will make you money so it’s best to accept loss on such trades. I have faced whipsaw many times and it’s best to cut out rather than firefight.
6. I have used Opstra for IV/strangle charts (still exploring icharts and ti looks promising). You can use any software.
7. Option selling comes with its own risk, so if you are not comfortable selling options and are already not doing it, this is best avoided.
8. To start with, take only 1–1.5X exposure — i.e. if the notional value for 1 lot of stock is say 8L, trade 1 lot only if you have 6L+. You can always increase the exposure to 2–3X as you get comfortable.
9. I trade this method all the time and have personally traded these stocks this week using this method.
Happy Trading !!