Risk is why Options exist. The very fact that buyer of the Option gets the privilege of a limited risk and unlimited reward pay-off profile (ideally speaking) means that Seller of the Options are getting opposite of that. Lots of risk of downside and limited upside is what Option Sellers get.
We all know that there is a higher success ratio that Option Sellers have Vs Option Buyers which motivates Option Sellers to take that risk. However, such risk of unlimited loss that option sellers have can be contained. For Option Buyers there is a risk of lower success rate, which can also be improved. The improvisation that I am talking about is removal of risk not worth taken.
Let us understand this improvisation technique with an example.
There are 2 Lottery Tickets with INR 100 to choose from.1. Gives you Return of 100 if Won
2. Gives you Return of 1000 if Won
It is an obvious answer that we would never buy a lottery that gives us INR 100 in Return (May Be) if we win. You would definitely go for the 2nd lottery.
This may not be the best example but clears a very simple concept that #1 has more risk compared to expected returns. Or shall we say, by taking Lottery #1 we will be taking a Dysfunctional Risk. A risk that is not capable of even equal rewards forget about 2X or 3X of the risk taken.
We do carry such Dysfunctional Risks in our Option Portfolios as well. Let us see how to get rid of such risks. We will look at dysfunctional risk removal for Option Sellers and then for Buyers. It is simpler than it looks.
Suppose with Stock X trading at 950 I sold,
Stock X 1000 Strike Call 10 days before Expiry at 10.
The stock remains there only and 1000 Strike Call with 2 days to expiry comes down to 2.
With difference between the Strike remaining almost same, I still run a risk of losing out if the stock were to move in the last 2 days of expiry.
More importantly, with 80% of my Potential gain in my Pocket. It becomes Dysfunctionally Risky for me to hold on to this Sell Option Position. Reason being, the trade has delivered most of it could deliver.So, improvisation technique is not taking the Dysfunctional Risk of Unlimited Loss for last INR 2 by exiting the position right now.
Improvisation I did is I converted a Likely Profit of INR 10 to Confirm Profit of INR 8. Anyone trading in stock market would appreciate power of confirmed profits.
I generally have an alert set for myself of 20% of my Sell Premium. Once my 80% is in, I exit.
Most of the Option Buyers are in the trade for the short term. Trades are taken most of the times in the underlying. So imagine there is a INR 1000 stock. I have a view that within 2 days the stock can reach up to 1030 and my Stop Loss to invalidate my view is 985.
Now, I take the Option trade of Buying 1000 Call Now 2 days pass by, I do not see 985, neither do I see 1030 on the stock. Many People keep the position open without keeping a tap on Passage of Time. For Option Buyers overholding your Option is the Dysfunctional Risk.
1000 Call with 20 Days to Expiry trades at INR 30
I have a Target of 1030 in 2 Days
If the Stock goes up to 1030 in 2 Days, Option Goes to 45
However, if I wait for the entire 20 days for the target and 1030 does come along on the day of Expiry. I would make Zero profits.
Meaning, holding the Option beyond a certain point in time was Dysfunctional Risk. Since the extra holding period did not give me enough rewards to justify my risk of Buying the Option.
Improvisation Technique: As soon as you have a trade in the underlying with a Stop Loss and a Target, choose your Option, use any option calculator and calculate what the Price of Option would be if your Underlying hits its Target and Stop Loss in your expected short-term.
Now, instead of monitoring the Underlying set a Option Stop Loss and Option Target alert on Premium in your analytics app, act when either one of them is hit.
These improvisations help in a lot of risk Optimization and removal of Dysfunctional Risk by making sure that there are no undue losses.Disclaimer: The views and investment tips expressed by investment experts on Moneycontrol.com are their own and not those of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.