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B. Venkatesh

CLASSICAL economics assumes that we make optimal decisions. This assumption has faced considerable criticism over the years. After all, we do find it difficult just to choose a dress to wear to the office. So, how can we make an optimal investment decision?

Yet, we are rational in that we do attempt to maximise our profits, especially through innovative methods. Switch trading is one of them. What is this strategy?

Switch trading effectively combines futures and options to improve profits. This term is used by Mitch Crask in his book Option strategies for sophisticated traders.

Suppose you expect Reliance Industries to move from Rs 650 to Rs 700. You can buy, say, the July 650 calls and sell the July 700 calls.

The advantage of such a spread is that the premium you receive by selling the higher strike call will lower the cost of buying the lower strike call. Simple math tells us that your profits will be higher because of the lower cost.

There is, however, one problem. The option premium contains time value. So, if you buy an over-valued call option, the time value will be higher. This essentially means that you will lose more money for each passing day if the stock does not move up. This is where switch strategy helps.

If you believe that the call option that you want to buy is over-valued, simply switch it with futures. So, switch trading will mean buying Reliance futures and selling the July 700 calls. Since futures do not lose value due to passage of time, you will gain even if the stock moves up from Rs 650 to, say, Rs 675 on the day the contract expires.

Now, would not a classical economist call this an optimal decision?

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