Weren't options invented to hedge risk? Yes, but now that's just in the books or in long-dated options.
Options are the most traded instruments in India today and a majority of the trading volume is contributed by the 'clients' category.
This is because FIIs use options to create synthetic futures, prop books take arbitrage strategies to make money and are generally hedged, but 'client' trades are the ones done with a speculative persepective.
Weren't options invented to hedge risk? Yes, but now that's just in the books or in long-dated options. The client category can be further sub-divided into HNIs and retail.
HNIs adopt various strategies but are largely writers of options, and on the other side retail investors are mostly buyers due to limited capital to invest and lack of knowledge.
But what has been motivating retail traders to participate in the options market? The answer is quick and large returns for small capital deployed. How many stocks do you think double every day? None. But more than 200 options double every day on an average and it's a race to buy these lottery tickets on daily basis.
Why am I calling it options lottery tickets? Because retail investors buy cheap options (deep out of the money) in an expectation for the price to double or triple quickly, the probability of which is extremely low. But a few jackpots can bail out all small losses and that hope keeps you alive in the game.
Let us now look at a few techniques that can raise the probability of you winning:
Buy out of the money options early on in the expiry cycle:
The options market is complex and multiple Greeks play different roles at different times. Buying an option in the early half of the expiry cycle is a good idea as the cost of theta decay is low and far-out-of-the-money options are still sensitive to underlying price changes.
As options approach the second half of the expiry cycle, the theta decay accelerates, making your probability of winning extremely low. At the same time, sensitivity to moves in option prices due to moves in the underlying reduces.
Identify fast moves:
Buying far-out-of-the-money options when the move is expected to be gradual may not payoff well. OTM options are sensitive to large movements in the underlying price and only in the event of fierce moves would these options would double. Identifying stocks or indices when moves are expected to be fast is the key.
Avoid known events:
The premium component for Vega i.e. volatility is high when an index or a stock has known, events and immediately after the outcome, volatility drops significantly and most of the time leads to sharp reductions in option premiums. Avoiding buying single OTM options in such situations can reduce the number of losing trades.
Keeping stop losses is very essential in trading and the same applies to the strategy of buying out-of-the-money single options. Premium erosion of 50 percent is huge and these would happen when the probability of the option expiring in the money has significantly reduced. Following a strict money management rule will add to the profit curve in the long run.Disclaimer: The author is CEO & Head of Research at Quantsapp Private Limited. The views and investment tips expressed by investment expert on moneycontrol.com are his own and not that of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.