How to avoid common mistakes when trading in options

Vikas SinghaniaTrade Smart OnlineOptions volume, both in indices and individual stocks in the Indian equity markets account close to 78 per cent (or close to Rs 85,000 crore of the daily volumes on the NSE). In fact, 94 per cent of the overall market volumes are contributed by derivatives (around Rs one lakh crore daily volume). Of which 60% is purely through Online (estimated at around Rs 60,000 crore daily volumes).  Both institution and individual traders pile up on this segment of the market. The reasons for both piling up on this segment of the market are however, different.If the trading call is right and momentum supports, multi-bagger returns are possible in option markets in a month, which in many cases in direct stock investing may takes years. Retail investors are attracted to this get rich quick possibility in a short term of the option market. Institutional investors on the other hand are keen on the mispricing that is rampant in these option markets. They are happy with smaller return but with a lower risk. Thus one would most likely find a retail investor buying an option where the return could be infinite but probability would be low. But an institutional investor would typically be taking the other side of the trade where the risks are low and so are the returns. The fact that institution investors generally come out victorious can be judged from the fact that more than 90 per cent of the options normally end up worthless. Thus a retail investor who would have bought an option would lose his entire money while an institutional investor would walk away with the small profit from the trade. If it is any consolation then the ratio of 90-10 percentage is valid even for the cash market, except the time frame is longer. Only 10 per cent of investors have made money in the markets over the medium to long term. New investors are attracted to the market with the promise of quick buck but lose out without understanding the game. The question is, in the option market what does it take to be in the 10 per cent trades which are winners. One way in ensuring success is to avoid mistakes, at least the most common ones. Highlighted here are some of the key mistakes a trader makes in the option market which are pulling him down. •Lack of understanding options: Many traders jump into option trading without really understanding the reasons behind the movement of options or the maths behind it. Little attention is paid to details like how much does an option move with respect to the underlying share or index, the Greeks that are used for calculation of option prices. Generally few traders know which strike price will offer the best risk reward trading opportunity is case of a small move or large ones.•Buying out-of-the-money options: Lack of understanding options results in retail traders buying options which are out of the money for the simple reason that they are cheap. An occasional win trade results in the trader getting fixated to buying out of the money options. In most cases even when the trader is right in his trade he loses money in the out-of-the-money trade since it requires a very sharp and fast move for these options to become profitable. It has been found out that trading in out of the money options is one of the biggest reasons for option trader loses.•Using one strategy that fits all: Option strategies are rarely understood and investors end up trading in vanilla call and put options and losing money in the process. These days many brokerages offer option trading strategies to choose from, making it easier for investors to select, but few investors utilise these services. •Not having an exit plan: Traders lose money because they do not know when to exit from an option position even if they are right. The fact that holding on to a position as time passes, erodes the value of the option is rarely understood. Similarly since the amount involved in options is small traders do not trigger the stop losses. They tend to hold to the trade in the hope that a move in their direction will result in a profitable exit. Ones an option goes out of the money as the underlying stock or index moves away from it, it would require a big move for it to come back to its breakeven level. •No clue of an event calendar: Option prices tend to over-react when an event is approaching. Investors read the rising value in options as a sign of a big move in its direction. Movement in option prices at the time of Infosys results announcement is the best example of how they rise without any appreciable rise in the underlying. Rising option prices is the premium that is being built in anticipation of a sharp move in either direction. •Writing options without proper risk management: Many times novice trader tries to behave like a professional trader and gets in the act of writing option where returns are limited while risk is unlimited. But he imitates the pro only partially. While a professional trader is either properly hedged in his position or keeps an iron tight risk management system of stop losses in case of a move against his position, a retail trader leaves his option writing position open. It just takes one wrong trade in this direction to wipe out months of gains for the trader. •Overtrading: One lot of 75 Nifty indexes is equivalent to around Rs 6.50 lakh. A future trader carries a Nifty position by paying a margin of around Rs 70,000 per lot. On the other hand an option trader at the start of the month pays only around Rs 12,000 for an at-the-money option with a chance to participate in the gains and losses of Nifty. In fact his return on invested capital in profit and losses is much higher than a future trader. But the fact that with Rs 12,000 only he can control Rs 6.50 lakh worth of assets gives the trader a false sense of wealth, which in turn results in buying higher number of options. •Lack of understanding of time decay: Another big factor that plays against a retail trader is lack of understanding of time decay on option prices. For as option price to rise the underlying stock or index needs a move in line with the option bet and fast. A grinding move plays against the buyer of an option. As time passes options lose value faster. Many retail traders hold on to their trade or take new bets close to the expiry of the market, because option prices are cheaper during this period. But most trades close to the expiry period turn out to be losing ones, unfortunately a novice trader holds on to his position since the amount involved is small. It’s these seemingly small loses are what cause the most damage to a novice trader.