Trading The Ultimate Momentum Signal
Now let us see how The Ultimate Momentum Signal can be used in different ways to enter in to the trades. And here are the different modes of entering in to the short term position trades.
1. Simple Futures Trades: Straight Long or Short positions in Nifty Futures in accordance with the momentum shifts indicated by the Momentum Signal. For example let us go back to the momentum shift which happened on 20th Jan. 2010 which is described in the page titled The Signal. Here is the chart of the the Nifty futures as on the date of the sell signal:
The suggested trade in this mode of entry would be selling of Nifty futures at the close at around the last traded price of 5214. The natural question which arise now is the stop loss point applicable to this trade. The suggested stop loss points for this trade is the minimum of (a) previous minor high, (b) previous two bar high excluding the entry bar or (c) 2.5 % of the of the futures closing price added to the closing price. If we examine the trade setup we can observe the following:
In case of long positions instead of the previous minor high and the two bar high(excluding the entry bar) the respective lows are applicable and instead of adding 2.5 % with the entry price it needs to be subtracted.
Nifty Future as on 20th Jan. 2010
The suggested trade in this mode of entry would be selling of Nifty futures at the close at around the last traded price of 5214. The natural question which arise now is the stop loss point applicable to this trade. The suggested stop loss points for this trade is the minimum of (a) previous minor high, (b) previous two bar high excluding the entry bar or (c) 2.5 % of the of the futures closing price added to the closing price. If we examine the trade setup we can observe the following:
- The previous minor high was formed at 5290.
- The two bar high excluding the entry bar is also the minor high at 5290.
- The entry price of 5214 plus 2.5 % of the entry value is 4319.
In case of long positions instead of the previous minor high and the two bar high(excluding the entry bar) the respective lows are applicable and instead of adding 2.5 % with the entry price it needs to be subtracted.
In addition to the absolute stop loss already described as above, the trade is also to be protected with a trailing stop of approximately 2.5% from the maximum favorable point achieved by the futures after the initiation of the trade. Therefore, the initial stop loss is adjusted downwards to the least of (a) the original stop loss or (b) 2.5 % points added to the low achieved after the trade. The trade is exited when (a) the Momentum Signal gives a neutral value or indicates a reverse trade, and/or (b) any of the stops, either the absolute stop or the trailing stop is hit. This is the riskiest way of entering the trades based on the Momentum Signal and therefore it may offer the highest reward.
Position Limit : The suggested position limit for this type entry is as described in detail in the next page titled Position Limits. Please understand the reasons for following the strict position limits and stop loss systems by reading the pages named Position Limits and Risk Analysis.
2. Futures + Short Options: Long or Short positions in the Nifty Futures in accordance with the Momentum Signal as described in (1) above together with opposite short positions in Nifty Options. For example a short position in Nifty future is accompanied by an equivalent short position in the Nifty put options placed at the money or slightly out of the money. This amounts to selling/writing Nifty put options leading to covered put positions. If the trade is to be initiated in the later half of the month and the expiry is nearby, the short options can be created in the next month series too. In case of the short trade indicated on 20th Jan. 2010, the position would have consisted of short futures at 5214 and short puts at the strike price of 5200. The profitability is limited to the premium received but in case of a slow favorable movement or a momentum reversal, the quantum of loss will be of lesser extent because of (a) some hedge available in the short options and (b) erosion in the time value of the short / written options.
In case of long positions the trade will be consisting of long futures and short position in calls of nearby strikes.
The futures positions in these trades are subject to the strict exit and stop rules described as part of strategy (1) above. If the futures part of the trade is exited because of a stop loss or indication of neutral momentum and not because of an indication of an opposite trade, the short options are also to be exited simultaneously. If an opposite trade is indicated due to a momentum shift, the short options part of the trade can be kept open as part of the strategy (3) described below with the applicable stop loss methods described in (3) below.
Position Limit : 150 % of the quantity calculated as per the position limit instructions given on the next page titled Position Limits.
In case of long positions the trade will be consisting of long futures and short position in calls of nearby strikes.
The futures positions in these trades are subject to the strict exit and stop rules described as part of strategy (1) above. If the futures part of the trade is exited because of a stop loss or indication of neutral momentum and not because of an indication of an opposite trade, the short options are also to be exited simultaneously. If an opposite trade is indicated due to a momentum shift, the short options part of the trade can be kept open as part of the strategy (3) described below with the applicable stop loss methods described in (3) below.
Position Limit : 150 % of the quantity calculated as per the position limit instructions given on the next page titled Position Limits.
3. Naked Option Selling: In this mode also a trade is initiated only when the momentum shifts it's direction just as in the above described two methods but by selling Nifty options placed on the opposite side of the new shifted momentum. This is tor taking advantage of value erosion of the short options due to (a) the expected favorable movement in the futures and (b) passage of time. For example if a long trade is indicated, at the money or slightly out of the money Nifty Put options for the current month or the next month expiry are sold. For the trade dated 20th Jan. 2010 the entry would have been made by selling Nifty Calls of the strike 5200 for the expiry months of Jan. or Feb. 2010. The Jan, 2010 options would have expired out of the money on 28th Jan. 2010.
The short options are exited in either of the following three scenarios; (a) the Momentum Signal indicates an opposite trade by momentum shift, (b) the short options doubles in value due to any reason; and (c) the short options expires out of the money. However, the trader may close out the positions when at least 90% of time value is eroded as a matter of abundant caution and to free up margins as there is no point in keeping a short option of meager value. In this mode of entering the trades the profitability will be limited to the option premium received, but trade management is a lot easier both practically as well as psychologically. In addition, passage of time also works in favor of the trader.
Position Limit : The calculation of the position limit under this mode of entry is different because of the difference in the stop loss method. Since the stop loss is fixed at the doubling of the written options, the position limit is fixed at where the premium income equals the risk capital allocated to the trade as a percent of the trading capital. For more information on the allocation of the risk capital, please read the page titled Position Limits. Let us go back to our earlier example of momentum shift dated 20th January, 2010. If the Jan. call options were being traded at a price of Rs100 and the total risk capital allocated to the trade was Rs30,000, the position limit is calculated by dividing the risk capital allocated by the price of the sold options. That is 30000 / 100 = 300 units which is equivalent to 6 lots.
The short options are exited in either of the following three scenarios; (a) the Momentum Signal indicates an opposite trade by momentum shift, (b) the short options doubles in value due to any reason; and (c) the short options expires out of the money. However, the trader may close out the positions when at least 90% of time value is eroded as a matter of abundant caution and to free up margins as there is no point in keeping a short option of meager value. In this mode of entering the trades the profitability will be limited to the option premium received, but trade management is a lot easier both practically as well as psychologically. In addition, passage of time also works in favor of the trader.
Position Limit : The calculation of the position limit under this mode of entry is different because of the difference in the stop loss method. Since the stop loss is fixed at the doubling of the written options, the position limit is fixed at where the premium income equals the risk capital allocated to the trade as a percent of the trading capital. For more information on the allocation of the risk capital, please read the page titled Position Limits. Let us go back to our earlier example of momentum shift dated 20th January, 2010. If the Jan. call options were being traded at a price of Rs100 and the total risk capital allocated to the trade was Rs30,000, the position limit is calculated by dividing the risk capital allocated by the price of the sold options. That is 30000 / 100 = 300 units which is equivalent to 6 lots.
4. Option Buying: This strategy consists of buying at the money or nearby strikes of Nifty options in accordance with the momentum shifts and profiting from the favorable momentum. This is the least riskiest of the trades offering a built in maximum loss protection to the extent of the premiums paid and will return lesser profits or losses in case of a slow down or reversal in momentum and/or due to erosion of time value.
This strategy may not make much profits if the market does not move immediately in the favorable direction of the trade, faster or significantly. However it will return higher profits than the strategies (2) and (3) above because of its unlimited profit potential on rare occasions. Passage of time acts against this mode of trade due to the erosion of time value. In order to limit the fast erosion of time value, it is preferable to buy the next month's options.
The suggested trade under this strategy on 20th Jan. 2010 would have been buying of the Jan. or Feb. puts for the strike price of 5200. If the Jan. puts were bought those would have expired at a price of Rs333, that is the strike price (5200) minus the expiry price (5867).
The suggested stop loss applicable to this strategy are (1) a reversal of the momentum signal and/or (2) erosion of 50% of of the value of the bought options whichever is earlier.
Position Limit : Since the stop loss method is fixed at the 50 % premium loss level, in this mode of entry, the total option premium paid is restricted to the double the risk capital allocated to the trade. In case of the above discussed trade, the trader could have used a total amount of Rs60000 which is 200 % of the risk capital allocated to the trade for buying the put options.
This strategy may not make much profits if the market does not move immediately in the favorable direction of the trade, faster or significantly. However it will return higher profits than the strategies (2) and (3) above because of its unlimited profit potential on rare occasions. Passage of time acts against this mode of trade due to the erosion of time value. In order to limit the fast erosion of time value, it is preferable to buy the next month's options.
The suggested trade under this strategy on 20th Jan. 2010 would have been buying of the Jan. or Feb. puts for the strike price of 5200. If the Jan. puts were bought those would have expired at a price of Rs333, that is the strike price (5200) minus the expiry price (5867).
The suggested stop loss applicable to this strategy are (1) a reversal of the momentum signal and/or (2) erosion of 50% of of the value of the bought options whichever is earlier.
Position Limit : Since the stop loss method is fixed at the 50 % premium loss level, in this mode of entry, the total option premium paid is restricted to the double the risk capital allocated to the trade. In case of the above discussed trade, the trader could have used a total amount of Rs60000 which is 200 % of the risk capital allocated to the trade for buying the put options.
5. Intraday Trading : Intraday traders may also use the signal as the higher time frame market direction finder and may allocate more capital to trades in the direction of the signal subject to their usual rules and risk return trade offs. They may also avoid taking trades against the signal's direction at least immediately after the indication of the momentum shift to increase the probability of profits and to reduce risk. In addition, the momentum of most of the Nifty stocks would be in alignment with the index momentum.
We have just described the basic structure of entries and exits using the Ultimate Momentum Signal. We have also described the position limits briefly and the methods of keeping the stop loss points in detail. Now let us try to understand why these rules are necessary to ensure the long term survival of a trader. Please read the next page titled Position Limits for a detailed description of the position limits. Also read the page named Risk Analysis.
Cheers and Prosperous Trading!
