How choosing right trading strategy could help lower risk

Suppose you compare two trading systems by back-testing on historic data over three years. Both deliver the same 20% CAGR. One system offers annualised returns of minus 10%, minus 4% and plus 100% in year one, two and three, respectively. The other system yields returns of +15%, +26% and +19%.

Most traders would prefer the second system. It delivered smoother profits. Psychologically, we equate smooth returns with lower risk. But this is not always true. A very risky system may yield smooth profits for sometime before blowing up. Conversely, a system with fluctuating return may possess less risk.

Let's take a simple example of a high-risk system that can deliver smooth returns. On January settlement day or one session earlier, a derivatives trader sells deep out of the money, February Nifty options. He receives high premiums due to the long time to expiry. If the option expires un-exercised, he keeps the premium. If the premium drops quickly due to moves in the opposite direction, he buys back earlier to release margin and book profits.

The trader repeats this strategy every month. It may make profits for many months in succession, if volatility is low. The returns will be smooth. However, sometime or another, there may be a big movement and the option is struck. Then, the trader could lose several multiples of the premium received that month and in theory, the losses may be unlimited.

Now, consider the inverse strategy. A trader buys deep out-of-money, February options just after the start of February settlement. He repeats this strategy and loses money, month after month, until one day, his position is struck. Then he makes several multiples of the premium paid that month.

In the second strategy, there will be an occasional massive gain offset by many small, predictable losses. But the strategy carries limited, easily managed risks and it also doesn't block margins. It may well be superior.

The risk:reward ratio for these inverse strategies depend on several factors. How often will the index make a big monthly swing and strike the out-of-money options? What premium multiplier can be expected if a deep out-of-money option is struck?

For example, if the premium multiplier is say, 5x when the option is struck and the option tends to be struck thrice a year, option buying has a positive risk:reward ratio. If the premium multiplier is lower, say 3x and it tends to be struck only once a year, the seller has a positive risk:reward ratio.

But whatever the concrete statistics, the “smooth strategy” carries a large indeterminate risk while the “volatile” strategy carries a small predictable risk. There are other trades like this, which can be similarly deceptive.

The author is a technical and equity analyst