Why Option Strategies?
The whole cosmos of stock markets as we know it can be divided into two: Cash segment and F&O.
Today we shall focus on the latter. The Futures & Options market is dominated by the big FII's and HNI players. We often see how retail investors end up losing their entire capital in just a few wrong trades. You must have heard the elders chiding you to play it safe, take small quantities of equity delivery and avoid F&O at all costs.
That's the part where most of us get it wrong.
The truth here is most of us trade options with inadequate knowledge & understanding. Options are a high risk- high reward game and are not for amateurs. It is nowhere close to trading intra-day swings in the cash market where anyone can hit the buy/sell button with just the basic command over numbers & strong intuition power.
Let us discuss some common mistakes which retail traders make while dealing with options.
1. Buying cheap out-of-the money call/put options - This is more like buying lottery tickets expecting to win it when the odds are against you. The premium paid by us is pocketed by the option sellers who know to make smart money.
2. Buying options in stocks with historically low volatility- Options are all about playing volatility. One must check the Vega and Implied volatility of an option before trading. Buying options in low beta stocks is seldom a profitable trade. Even if low premiums entice you, it's better to stay away and buy futures as you can avoid time decay.
3. Having no exit plan - This is the thumb rule whilst dealing with options. You've often heard everyone ranting about stop losses but truth be told only a handful follow this principle. Trading without stop losses can be devastating. Do not worry that the stock changed it's course as soon as you sold it. Remember the market always rewards disciplined traders over a period of time.
4. Over leveraging- Say we have a capital of 1 lakh for trading stocks. Newbies in the options world often forget that the cash market is relatively safe and the entire amount invested in a single stock will not turn to zero. Such is not the case with options. We can buy a huge quantity of stock options with the same amount of money as we only have to pay a fraction of the stock price. Leverage is a dirty game and should be avoided as much as possible
Lastly and most importantly,
5. Naked option buying/selling- One word to sum it: DOOMSDAY. This is the most disastrous mistake which people make on a day-to-day basis. Trading in naked options is awfully risky and may end up in huge losses. Remember, the market can make wild moves from time to time.
A recent example of this phenomenon is 20th September,2019. The day when our finance minister announced the corporate tax rate cut.
The Nifty Index closed at 10705 the previous day. In two days, the market made an intraday-high at 11695. A lot size of 75 implies on paper losses of 74,250 per lot considering the investor shorted a 10700 call. That's humungous!
So, what do you infer from the above? Is it better to be an option seller or an option buyer? It just takes one single naked selling trade to become bankrupt. Being on the other side of this, you can say that being a retail buyer would have fetched you profits in this trade but that is once in a blue moon opportunity as it was one of the highest movements of the decade. Come to think of it, it is nothing short of a lottery, and we all know how rarely one gets to be lucky enough to hit the jackpot.
Now just imagine if the investor would have longed the 10,800 call simultaneously to hedge himself. The overall losses could have been limited to a mere 7,500 per lot.
Option strategies are undoubtedly the best instrument to maximize our profit potential and cut down on our loss-making trades.
As quoted by the Oracle of Omaha aka Warren Buffet,
"Rule No. 1 - Never lose money
Rule No.2 - Never forget rule No.1"