Have you ever wondered why is it that 80% of the traders who buy options tend to lose money? You can argue that you only lose the premium but that is not the point. If you lose the premium on your options 5-6 times in succession, it can demoralize the best of traders. The funny part about options is that most people get the basic logic of their options trade wrong. And more of than not, this is entirely avoidable. To understand why traders make loss in options trading, let us look at some common option trading mistakes that people commit. That will help us understand why most options traders lose money.
1. Don’t buy deep-out-of-the-money (OTM) options just because it is cheap
If SBI is currently quoting at Rs.280, the Rs.290 call option may be available at Rs.7 but the Rs.320 call may be available at Rs.1.25. That does not make the Rs.320 call option cheap. It is quoting at Rs.1.25 because the probability of SBI crossing that price is very low. Deep OTM options are a lot like penny stocks with low P/E ratios. They can work as a perfect value trap. Most options buyers calculate that if you lost Rs.1.25 on a lot size of 3000, then you loss is just Rs.3,750. But then, you trade options to make money, rather than not to lose money.
2. Options are decaying assets and you need to play accordingly
The option value that you see on the price screens has two components viz. intrinsic value and time value. If the RIL 1300 call options is quoting at Rs.27 when the market price is Rs.1308, then the intrinsic value of the options is Rs.8 (1308 - 1300) and the time value is the balance premium Rs.13 (21 – 8). This time value is a wasting asset or decaying asset since it converges towards zero by expiry data. The fall in value is very rapid in the last few days and hence you must never hold the option too close to expiry.
3. Even options require stop losses to protect your loss
Let us say you bought a Tata Motors 300 call options at an OTM premium of Rs.8. With just one week to go you don’t see chances of TAMO crossing that level. The options is now quoting at Rs.3. Should you hold till expiry or save Rs.3. The answer is that you should close the position and save Rs.3. Even in options stop losses are required because when you can save your losses why should you bear the brunt of the full premium. For an options trader this approach can make a lot of difference between profits and losses. Should you keep stop losses when you buy an option. That would depend. When you buy ATM options or ITM options, then you normally pay a higher premium. In these circumstances, it makes more sense to keep a reasonable stop loss to least recover part of the sunk-option-premium. Even in case of deep OTM options, if there is low probability of breaking even, you can take a call to recover as much as possible on the option.
4. How about keep your options trading simple and plain vanilla?
Options are simple products but can also be combined to create limited loss strategies. That is fine. One can create a Strangle by buying a higher strike price call option and a lower strike price put option. That way you make money from the volatility in the market. But there are complex strategies in options that have 4-5 legs. When you create so many on one side, you need an equal number of legs to close the strategy. Apart from the margin requirement, you also do not know if you are net long or net short. Then there are the big transaction costs in the form of brokerage and statutory costs. Ideally, use options to hedge your equity risk. If you are trading options, keep it simple and in sync with your view on the markets.
5. In options, buy into volatility and sell into stability
This is where most of the option traders get their view on the stock wrong and make a mess of things. When markets and stocks become volatile, options become more valuable. Volatility means the stock or index can swing wildly either ways. On the downside, your risk is limited to premium but on the upside your returns can be boundless. That is what makes volatility work in favour of options prices. So when volatility rises, it is time to buy options and not to sell options. A lot of traders look at purely the price aspect of options and not the volatility of the options.
However, options are asymmetric (limited losses and unlimited profits) because of which volatility matters a lot. For example, when the stock price goes up, call options benefit and put options lose the premium. When stock prices go down, put options make money but call options lose the premium. There is another angle to it. Even if the stock price remains static, an increase in volatility can increase the option price. The rule is to always play on the side of volatility. When volatility is rising, you should be buying options and when volatility is reducing you should be selling options. It is when you play against these rules that you lose money in options.
6. Like in the case of stocks, there are underpriced and overpriced options too
An option, like a stock or any other asset class, can be underpriced due to various reasons like time factor, volatility factor etc. How do you find options that are underpriced and overpriced options. You will have to use the Black & Scholes formula which calculates whether the option you are trying to buy is overpriced or underpriced. You need not worry about with the nuances of Black & Scholes method because this calculator is available on your trading terminal and also on the NSE website. You can just input some basic details and find out if your option is underpriced or overpriced. This is a necessary check before buying or selling options and can go a long way in reducing your risk of options trading.