Did you know that globally nearly 80-85% of the options expire worthless. That means; the buyer of the option loses money on the option while the seller actually takes the premium. There could be two reasons for the same. Firstly, the option buyers are normally the smaller trades while the option sellers are normally large institutions. Secondly, attractive options tend to be fully priced and deep OTM options are anyways worthless. As a result, time works much harder against the option buyer and in favour of the option seller. First, let us understand what exactly is an option?
An option is an asymmetric derivative product where the cash flows of the buyer of the option and the seller of the option do not sync with one another. This is unlike futures where the buyer and the seller have unlimited potential for profits and for losses. When you buy an option you get the right without the obligation. A call option is a right to buy without the obligation and a put option is a right to sell without the obligation. Since the option loss is restricted to the premium paid, the maximum loss is capped at the total premium. Once the option cost is covered, the option profit can be unlimited on the upside. That explains why option buyers find it attractive. Let us now focus on option payoffs.
How the option pay-off pans out for the option buyer…
Let us assume that Rajesh has purchased a 600 call option in the current expiry on Tata Steel at a premium of Rs.15 when the spot price was Rs.592. In this case, Rs.600 becomes the strike price while Rs.15 is premium cost or the option cost. This also represents the maximum loss on the position that the buyer of the option, Rajesh, will have to incur under any circumstances. How will the option pan out under different conditions?
|Price Scenario||Profit / Loss||Option Cost||Option P/L||Net Pay off||Action taken|
|570||0||15||-15||-15||Left to expire|
|580||0||15||-15||-15||Left to expire|
|590||0||15||-15||-15||Left to expire|
The three different colours in the above table show the three different levels of payoff that the buyer of the option will get…
- In the scenario marked by the yellow shade, the price of Tata Steel is below the strike price of Rs.600. The option is Out of the Money (OTM) for the buyer. The option buyer will just let the option expire. What about the Rs.15 paid as premium on the option? That is a sunk cost for getting the right to buy without the obligation to buy Tata Steel…
- In the scenario shaded is shaded in light blue, the option is either at the money or in the money but the buyer is still making a loss due to the cost of the premium. The option will still be exercised at this point to reduce the loss for the buyer.
- In the scenario shaded in grey, the trader is actually making a profit on the option position even after considering his premium cost. In the above case of call option, the fixed premium cost is Rs.15, so above Rs.615, the buyer of the call option starts making net profits and this will continue linearly on the upside.
5 reasons why the option buyers tend to lose money…
- Quite often investors tend to buy deep OTM options since the premium is very low. But the problem here is that it is low because the probability of reaching the level is low. That is not a sign of attractiveness. Also, since this is an OTM option, the entire value of the option is time value and so time works against you.
- Traders lose money because they try to hold the option too close to expiry. Normally, you will find that the loss of time value becomes very rapid when the date of expiry is approaching. Hence if you are getting a good price, it is better to exit at a profit when there is still time value left in the option.
- Quite often traders lose money on long options as they hold the option ahead of key events. For example, if you had bought an OTM call on Infosys expecting good results and if Infosys disappoints then your OTM call options is going to be almost worthless.
- Acting too bullish on a moderate bullish view is not a great idea. If you are moderately bullish on a stock then prefer a bull call spread rather than a naked call option. At least, you will reduce your overall cost of the option.
- Option is like an insurance policy and it is meant to hedge your downside risk. Have you heard of people making money by buying insurance? It is only the insurance company that sells you insurance which makes money. That is why it is hard to make profits by buying options.