7 reasons why options traders get it wrong…

Stock Market | Published on 15th June 2018 | 249

Did you know that more than 80% of the traders who buy options tend to lose money. Of course, you can feel smug that you only lose the premium, but that is hardly any consolation. Remember, that an option is different from futures in the way it is structured. A future is a symmetrical product. That means; the profits and losses can be technically unlimited for the buyer and the seller of the futures. Option is asymmetrical; the profits are unlimited for the buyer but limited for the seller. At the same the losses are limited for the option buyer but unlimited for an option seller. How do options traders generally get it wrong? Here are 7 ways options traders get it wrong.

Buying OTM options just because they are cheap

A deep out of the money (OTM) option may appear to be quite cheap in price terms. But that is more because the probability of reaching that price is very low. If SBI is currently quoting at Rs.260, the Rs.270 call option may be available at Rs.8 but the Rs.310 call may be available at Rs.1.25. That does not make the Rs.310 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 typically a buyer’s trap and that is where many small and retail investors tend to get caught.

Holding options too close to expiry

Every option has two components viz. intrinsic value and time value. If the SBI 260 call option is quoting at Rs.10 when the market price is Rs.266; then Rs.6 is the intrinsic value (266-260), while the balance Rs.4 is time value. The time value of an option reduces as the expiry approaches. That is because, on the date of expiry all options will have time value of zero. The fall in time value becomes rapid in the last 1 week to expiry. That is why most traders who try and hold options too close to expiry tend to lose money.

Not setting stop losses while selling options

When you sell options, it is just like selling futures as your losses can be unlimited. So always keep your stop losses when you are selling options. That is straight forward. But 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 stop loss so that you can at least recover part of the sunk-option-premium. Even in case of deep OTM options, if you find there is low probability of making profits, you can take a call to recover as much as possible on the option.

Not grasping the difference between intrinsic value and time value

This is true of ITM options. In case of OTM options, there is only time value so there is no confusion. But, ITM options have time value and intrinsic value. The difference is critical because intrinsic value is a play on the price of the underlying stock while time value is a play on volatility. Higher the volatility, greater is the time value assigned to an option. Once you understand this difference and work the split, you will be in a much better position to work your options trades profitably.

Creating complex strategies with too many legs

Options are simple products but can also be combined to create limited loss strategies. That is fine. For example one can create a Strangle by buying a higher strike price call option and a lower strike price put option. That way you just make money from the volatility in the market irrespective of whether the market goes up or down. The entire scenario becomes complex when you get 4-6 legs into the strategy. Why is it not a great idea? When you create 6 legs on one side, you need another 6 legs to close the strategy. You can add up the margin required, the brokerage cost and the statutory costs for these six legs. Also when your strategy becomes too complex, it is hard to decipher how this strategy gels with your other positions.

Playing against the rules of volatility

Why do option prices move. There are two factors that move option prices. Firstly option prices move when the price of the underlying stock moves. For example, when the stock price goes up, call options benefit and put options lose money. When stock prices go down, put options make money but call options lose. The second criterion is volatility. 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.

Not focusing on underpriced and overpriced options

How do you find options that are underpriced and overpriced options. There is a methodology called the Black & Scholes formula which calculates whether the option you are trying to buy is overpriced or underpriced. You need not obsess yourself with the nuances of the Black & Scholes method but this calculator is available on your trading terminal and also on the NSE website. You can impute the details of the option and determine whether it is underpriced or overpriced. Always conduct this check before you take a position. Ideally, you should be buying underpriced options and selling overpriced options.