How to trade options profitably

A successful self trader – Rule # 30

According to a global study, over 90% of people who buy options lose money. It may appear that selling options is a safer proposition. Not exactly! When you buy options, there are components to that decision. What strike to buy; at what premium to buy; how much time value to pay etc. Unless you understand these finer points of buying options, you will be on the losing side. How to join that other 10%?

HOW TO BUY OPTIONS AND NOT LOSE MONEY

 Buying options is not rocket science. But it is not just about determining the direction of the market and deciding to buy a call or a put option. An option is a lot more complicated as compared to plain vanilla futures. There are four unique features of options you need to remember. Understanding their interplay can go a long way in helping you become a smarter player of the options game.

Firstly, an option is a time value game. When you pay a premium for buying an option, you are paying for the price difference and for the expectation of price movement. Secondly, being a time value game, it is a wasting asset. For example an out-of-the-money option will keep losing value consistently in the beginning and rapidly towards the end of the month. Time works against the buyer.

Thirdly, buying options always works best in a volatile market. Both call and put options tend to become more valuable in a volatile market and less valuable in a flat to range-bound market. Lastly, options are primarily hedging instruments and hence they should be predominantly used for counter balancing your risk in other investments. Options as trading choices should always be secondary.

3 QUESTIONS TO ASK BEFORE BUYING OPTIONS-

PROXY FOR PRICE OR PROXY FOR TIME

 If you are buying options as a proxy for price, ideally stick to in-the-money options where time value is limited. If you are willing to bet on uncertainty over a period of time, then prefer out-of-the-money options. That is the key.

 IS IT A HEDGE, OR IS IT A BET

 As mentioned earlier, buying options should primarily be for hedging. But one needs to be clear on the purpose. In a hedge the net cost and the breakeven matters. In case of a bet, the cost and volatility matters. Touché!

 WHAT IS MY COST OF TRANSACTING

 Options have become cheaper to trade, but read the fine print. Are you paying fixed brokerage per lot or variable brokerage? This matters when you trade in bulk. The statutory costs also add up. When you are trading on wafer-thin margins, costs matter a lot.

 “Derivative instruments like futures and options have the potential to become weapons of mass destruction” – Warren Buffett

 

6 STEPS TO A SOUND OPTION BUYING STRATEGY

  1. Don’t get obsessed with buying out-of-the-money options. It may appear to be a good bet as the downside risk is low. Remember, deep OTM options are cheap because they are actually worthless. You may end up getting upset over the OTM options you keep on buying, that expire worthless. Be careful.
  1. There are investors who say that they are bulls or bears and hence they will only buy calls or puts. This kind of a one-size-fits-all strategy will never work. Buying options is all about being fleet footed to grab opportunities. You must be open to buying calls, puts or even synthetics like strangles. Period!
  1. Check if the option is underpriced before buying it. Your broker trading terminal or even your online interface has a simple algorithm, which identifies which options are underpriced based on the Black Scholes Model. While this may not be a sure-shot money spinner, it definitely gives you a margin of safety.
  1. Do you want to buy index or stock options? It depends on what you are trying to bet on or hedge against. If you are looking at broad macro factors like GDP, fiscal deficit, currency etc, then stick to index or sectoral options. If you are looking at company-specific factors, then focus on stock options.
  1. Beware the liquidity trap. Check the past liquidity of options before jumping into them. This is very true of options on mid-cap stocks. You surely don’t want to end up holding a pile of illiquid options. Check that you can exit in bulk from that option, without disturbing the price too much. That’s critical.
  1. Options buying is all about moderation. Avoid concentrating on just 1-2 options and don’t spread yourself too thin. Set a target for option premium and exit. Avoid waiting till the rapid time-value erosion starts. Avoid the temptation of buying more to reduce your average cost of options. It rarely works.

RISKS TO AVOID WHEN BUYING OPTIONS

 There are those eager beaver traders who buy a certain option just because a particular institution or star trader bought it. Perish that thought. You don’t know what is behind their trade. Also don’t buy a call option, the moment you are convinced about the fundamentals of a stock. It may take 3 years for the stock price to fructify. By then your options cost may well and truly finish you. Avoid the bandwagon strategy while buying options.

Remember, a cheap option is not necessarily valuable. It is most likely cheap because that is what it is worth. Averaging is a cardinal sin. An option trader once told me that he had reduced his risk in an option by buying on every dip. That is a myth. While your average cost of holding may have come down, your concentration risk is substantially up. Be cautious of illiquid options for two reasons. Firstly there is a danger of no exit and secondly, it normally attracts regulatory scrutiny.

TAKEAWAYS FROM THE “OPTIONS BUYING” DEBATE

The gist of options was best summed up by the legendary George Soros. “Markets are constantly in a state of uncertainty and flux. Therefore money is made by discounting the obvious and betting on the unexpected.” Buying options provide the best route to bet on the unexpected. For the past many quarters, Infy has been volatile on the day of results. Buying strangles (a call and a put simultaneously) has almost always worked in case of Infosys. Watch out for such mug trades in the market.

Option buying is surely more complicated than buying equities or plain vanilla futures. But then, you at least know your worst case scenario. The aspect of time value surely adds a new dimension to it. There are some basic building blocks to a smart options buying approach. If you focus on options valuation, scientifically decide the strike to buy, monitor your position carefully and avoid the standard pitfall of averaging your position on each dip, you too can be a fairly successful options buyer.

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