Breakout trades can give handsome returns. So can reversal trades. This week, we discuss a reversal trade considered aggressive, and therefore, risky, taking a combined short position in futures and options. The objective is to have futures position benefit from the directional movement in the underlying while capturing time decay and delta gains from the option position.
Bull exhaustion
It is efficient to initiate short position in futures compared to a short position in the underlying. This is because you can carry your short futures position till its expiry (naked short). Suppose you identify bull exhaustion in an underlying, which can be a stock or an index. Suffice it to say that the early signal of such bull exhaustion can be detected from single or multi candle line patterns and volumes. Based on this signal, suppose you set up a short futures position. This will allow you to capture a near one-to-one movement in the underlying.
But what if you are confident about your view on the underlying? You can also set up a short call position. Note that you are setting up this position based on a bull exhaustion. This means the price would have seen a prior uptrend. During that period, there would have been greater demand for calls. Now, greater demand for a call option will push its price up. A higher price translates into a higher time value, for a given underlying price. The time value of an option has two components: time to expiry and implied volatility. As time to expiry reduces with each passing day, any increase in time value will translate into higher implied volatility. In other words, an increase in option price, given the underlying price, can lead to increase in time value, translating into higher implied volatility. But this time value must become zero at expiry. Therefore, when you short an option with a high implied volatility, you are attempting to gain from time decay.
In the context of a bull exhaustion, this could happen for two reasons. One, as the underlying declines, the falling demand for calls could lead to lower implied volatility. And two, with each passing day, the time to expiry also reduces. Therefore, time decay could accelerate, providing the opportunity for gains on the short call position. You can also capture gains from decrease in delta, as the call option loses value. The position is subject to high risk. If the bull exhaustion were merely a pause before the price continues its uptrend, the position will incur large losses.
Optional Reading
The position requires large trading capital because you cannot avail cross-margin benefits. This is because the position has same-side directional risk. Both short futures and short call will incur losses if the underlying moves up. For this reason, you must manage the position with tight stops. Note that the stops on short call position must be based on the futures (underlying) price when trading indices (stocks).
(The author offers training programmes for individuals to manage their personal investments)
Published on May 10, 2025