Options have their genesis into the principle of risk transfer. As fantastic as they are in moving the risk element of directional trading from the ones who have it and wants to avoid it to the ones who would want take that risk for some consideration.
Nonetheless, the productivity of this additional risk for risk takers or of the consideration for the risk transferrers is a critical factor to keep evaluating. This is one exercise which is seldom done. Result of this can be seen in instant dislikes that many option traders create in first few trades.
Let us evaluate the same and see the corrective actions that can be taken to eradicate this unproductivity element and improve the pay-off. Two individual transactions of Buy Option and Sell Option can be evaluated individually for their productivity and edits can be made.
To start with, the Sell option position that we have has a risk of undefined, unknown magnitude of the unfavourable move that can come along and the reward is the consideration in other words premium revived. Now let us keep in mind this reward will keep on accruing its benefits as the days go by considering the price does not move against the position.
While the risk management is often given apt consideration in case the underlying moves against us and the position starts bleeding. Not many of us though, would go ahead and pay attention to the drop in premium in our favour.
Taking an example of a Bull Spread where there is one Buy Call and one Sell Call involved, consider a drop in price. In this case both the options would lose the premium. However, in case the fall is fierce enough to eradicate 80 percent of the premium value of the option sold, then there is not much left into it in terms of reward. However, the risk is still outstanding.
This is the case where the risk from that 80 percent premium degraded option becomes unproductive. Here the best solution is to get rid of the option sold, since it has done the job that it was set out to do.
This was about handling unproductivity of Risk, let us now discuss handling unproductivity of the premium or the Consideration paid for risk transfer. There is one particular trade that comes to mind to understand this better. Consider a Buy position in single Call option in the first half of the expiry.
More often than not, option traders would treat the premium paid as sunk cost and write it off. However, in case of a little deeper unfavourable move, the premium would drop significantly. Still in this case because there is ample amount of time left for the expiry, there would still be value in the premium attributed to the time.
Now, there is unproductivity involved here because if it takes a lot of time for a favourable move to undo the damage and even reach up to our strike and we will still lose out. So, close that unproductive Single option. Since we had Buy Call, we can create a Bull Spread by Buying a Call rather closer to the fallen price and Sell a higher Call. Make sure that the net premium outflow matches the left out Premium that we received after selling the single Call bought.
Best to use when there was a grinding fall over 2-3 sessions and not a one-day sharp fall. Risk of losing out of profit potential does remain but still we are better off in terms of odds of making money in this than holding on to the bleeding Single Call that we had bought.
These are just some of the tactics but in a nutshell dissect and analyse the potential productivity of every option bought or sold during the lifecycle of the trade and improve your pay-off by optimizing on the productivity of each leg.
(The author is CEO & Head of Research at Quantsapp)Disclaimer: 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.