Strategy for regular income from market

In this thread, I'll be sharing the strategy to earn regular income from market. This might not suit everyone and do this only if you are comfortable with. Assumption: Readers will know about options.

Strategy: Short Strangle

On What: Nifty option contracts

Expected return: 1-2% a month on the capital

Minimum capital required: 1L (About 40k is the margin required to sell one lot of nifty and since this is two sided strategy, need about 80k. For simplicity of calculations, let's keep as 1L)

Holding period: Up to a month allowing the contract to expire worthless, but can exit when in good profit or when SL hits

Assumption: VIX doesn't shoot up much when in position

How it works: Option premiums decay over time and we sell when there is good time to expiry so there is time value in premium and exit (buy back) closer to expiry at much lower price. So the net is realised profit.

Strikes to choose: Ensure that strikes we are selecting are deep OTM and never becomes ITM during our holding period. Selection of strikes place an important role in making returns. On an average (I need to do some checks on historical data), Nifty doesn't move beyond 5% in an expiry in about 9-10 months in a year. Rest of the months it moves big. Assume nifty spot is 10400. Let the OI build up on both call and put. Look for maximum concentration of OI in both sides. These levels will be held by the option writers mostly. Pick the strike beyond that level. In this case, most people will sell 10,000PE as it is psychological level and most expect it to hold. So DON'T short 10,000PE, instead pick the next support level based on daily nifty chart which is 9800. So short 9800PE. On the call side, 10500 will act as resistance followed by 10700. But pick 10,800CE to short. Or even 10,900CE. So we are taking 600 points down and 400/500 points up.

Premiums: Look for 15-20 points premium, DON'T get greedy and pick a closer strike aiming for more returns, thats the trap where most fail in this strategy. Even if we make 15 points profit per lot, returns will be 15*75=1125 using 50K margin (one lot). Since we are doing two lots, total returns is 2250 using 1L margin (2 lots) which is 2.25%.

Compounding factor: 2.25% will seem to be too little for most of the traders who miss to see the bigger picture. Assuming there is no profit on two months in a year, this can still make about 20% returns a year, which is way ahead of many asset class returns. It is easily said than done. One need to gain experience and correct the mistakes done and learn from the trades. Over the time, one can master this strategy and make this a regular income one.

I'll provide additional information in later posts. Please share your comments/feedback.

Stop Loss:

This is a tricky part and has to be decided case by case basis. There are times where I didn't keep stop loss and booked big losses. Later I decided to keep stop loss as 2x of premium collected. For example, if I'm selling for a premium of 20, I'll keep stop loss as 40. Most of the times, it got hit and reduced again. So I changed to 3x. It worked for most of the times, but one need to key in stop loss order every trading day. But later I realised that I was hitting stop loss because of incorrect strike selection. Premium goes near 100 for a contract when spot comes near by that strike. So more focus should be paid to selecting the strike price to sell the option. Also remember that market doesn't move in linear fashion. If market is falling day after day, put premiums will shoot up and will be more costly. But just a day of consolidation or a positive close is what required to remove all extra premium on put options. There will be two to three months in a year when Nifty will move big and you can predict them to some extent. Around budget or any big election or a major global event. Event like demonetization can't be predicted and that's the risk one has in market. So try to go light in number of lots in such months or allow for event to pass through and then create positions if you must trade.

Nowadays I don't keep any stop loss as I've learned a lot in picking the strike and getting losses earlier. Now the returns are consistent. For example, I shorted 11,100CE of Feb-2018 option. I didn't keep any stop loss and overall loss was about 10% of total capital. But still the one way up move can't sustain and so I didn't close the position and everyone knows what happened post budget. 11,100CE expired worthless which once had a premium of around 200.

So keep SL as 3x if you are new and start option selling with one lot on each side. Do this for a year, it will test your patience. If you can manage to be profitable for 8-10 months, you are good to increase the lot quantity. But word of caution, one wrong month will wipe out profit of one full year. Don't be over confident or get greedy for more returns. Target only around 2%.

Margin to trade: Since option selling has theoretically unlimited loss if not done properly, margin requirements are high. To sell/write a Nifty option contract, almost 40k is required. TO do both sides, it is 80k. To have some cash in account, let's say we need margin in multiples of 1 Lakh to do selling on both call and put. Most will think 2% is very low return to get from market with capital of 1L by selling options where the capital is locked for full month, instead one correct future trade will give much better returns. It is correct, but probability of getting a winning trade in futures is much less than being profitable in selling options.

But the interesting thing is, one need not have cash to cover all margin required to sell options. If one has 1L capital, I would say to buy equity in cash for 80k leaving 20k in cash. Pledge 80k worth of stocks to get margins of about 60K-65K. With this margin and remaining 20k cash, one can sell one call and one put option of nifty. If one can manage to make about 15-20% returns a year by selling options and if portfolio grows by 15-20% a year, one is making around 30-40% a year. What more one needs from market than such returns. Even on a bear market where portfolio doesn't grow much or falls 10%, option selling can still be profitable if done properly.

This link can be referred to know how to pledge equity in Zerodha.
//zerodha.com/z-connect/tradezerodha/margin-requirements/online-pledging-of-stocks-for-trading-fo

If one is using the margin from pledging equity, more care should be given to ensure that you are not ending in loss. Because, pledged equity will get sold if margin is not sufficient due to losses. Use this strategy to enhance the return from portfolio and not to lose the long term portfolio. If you are not comfortable with this strategy, please don't do this. Selling option without understanding will result in big loss.

Exchanges now require 50% of margin to be met by cash. So if you have got 1L margin by pledging the portfolio and if you want to use that to sell options, you need to have another 1L in cash so you can trade with 2L margin. But if you just use only pledged margin, there is interest of about 0.05% per day on the amount of shortfall. But I don't use 50% cash and will pay interest. I used to have 20% cash and rest 80% will be from pledged margin. More details on this penalty can be found in Zerodha link I shared in above post. Copy pasted below for quick reference:

Exchanges stipulate that for overnight F&O positions, 50% of the margin needs to compulsorily come in cash and the remaining 50% can be in terms of collateral margin. If you don’t have enough cash, your account will be in debit balance and there will be an interest charge also called delayed payment charges of 0.05% per day applicable on the debit amount. So assume you take positions that require a margin of Rs 1 lakh, you will need at least Rs 50,000 in cash irrespective of how much collateral margin you have. Assuming you don’t have this Rs 50,000, whatever you are short by will be the debit balance for the day, and interest will be applicable for that amount.

All interest accumulated will be debited once every month on the ledger. A link to see cumulative interest calculation can be found on the holding page itself.

All pledged stocks will be debited from your demat account until they are unpledged again. The entire process of pledging and unpledging will cost Rs 60 per scrip irrespective of the quantity. So if you pledge 100 shares of Infosys and 200 shares of Reliance, the total cost (pledging + unpledging) will be Rs 120 (Rs 60 x 2). This charge will be debited from your ledger the day you place the pledge request.