Three Biggest Mistakes In Option Trading

Option trading today is more popular than ever and as markets get more volatile than usual, option trading looks to be the most promising way to profit from the markets. While participation has been increasing in the complex world of option trading, the mistakes made by option traders are also quite visible. Geyatee Deshpande shares insights on the common fallacies that option traders suffer from and also suggests how best to avoid them.

There is no doubt that options offer traders and investors a number of outstanding money- making opportunities. Some market participants (speculators) can buy options and enjoy the possibility of unlimited profits with limited risk while others can employ a strategy using options that offer extremely high probability of profit. If this is not enough to excite market participants, investors can also use options to hedge other existing stocks or even futures positions for that matter. In spite of all these possibilities that can be explored using options, it is estimated that an overwhelming majority of option traders end up losing money in the markets in the long run. This raises some questions:

☛What is it about option trading that causes so many traders to fail? 
☛ Should one trade in options at all?
☛What can be done to avoid common mistakes while trading in options?

If such a large number of option traders make common mistakes and lose money in the markets, one can raise an additional interesting question here: can we have an edge in option trading if we identify the common mistakes that a majority of options traders make? The good news is that by isolating such common pitfalls and understanding why such common mistakes occur on a regular basis one can start avoiding them and start taking a major step towards becoming a successful option trader.

Mistake 1 

Relying Solely on Market Timing

One of the most common mistakes a majority of option traders make is too rely too much on the ‘market timing’ to buy ‘call or ‘put’ options. Market timers believe that all it takes is to get the market timing right to make money in option trading. And on top of it another common belief that market timers have is that buying any call or put option of the underlying security will make money if the market timing is correct.

This is factually not correct and one of the major reasons why market timers lose money in the long run. Relying solely on market timing will yield positive results in a few trades here and there but the missing factor will be consistency, which in fact is the most crucial aspect in differentiating winners from losers in the long run.

All market timers have to do is understand the fact that even when the call option is bought at the time the underlying security has touched bottom, it does not guarantee good profit or at times may generate negative returns. Not to ignore the fact that even the best of market timers cannot time the markets perfectly. It is almost impossible to accurately time the markets and what we are facing here is a situation in option trading that even if the market timing is accurate the option may not yield the desired profit just because the trader got the market timing right. The focus has to be on ‘implied volatility’. 

The trick for success in the long term for any option trader is to identify whether the current level of implied volatility is high or low for the given underlying security. Further, the trick is to buy an option when the implied volatility is low and sell an option when the implied volatility is high. It is found that a majority of option traders who strategize their option trades purely on market timing totally ignore the importance of interpreting implied volatility, which is what proves to be fatal in the long run for the trader. 

What is Implied Volatility?

While trading options, implied volatility (IV) is one of the most important metrics to understand. IV is determined by the current price of the option contract of the particular stock. It is represented as a percentage which indicates the annualised expected one standard deviation range for the underlying based on the option prices. For example, an IV of 25 per cent on stock of Rs 200 would represent a one standard deviation range of Rs 50 over the next year. One standard deviation means that there is approximately a 68 per cent probability of a stock settling between Rs 150 per share and Rs 250 per share in one year.

As to why 68 per cent probability, the reason is that in statistics, one standard deviation is a measurement that encompasses approximately 68.2 per cent of the outcomes. Tracking IVs is important as the IV figures tell us which stock options have more embedded uncertainty. Basically, when uncertainty increases, the stock’s option will become more expensive. IV increases when the stock option prices increase owing to uncertainty. This is also known as IV expansion. Ideally, an option trader should enter a trade before the IVs expand. 

Mistake 2 

Buying Out of the Money Options

A majority of the option traders choose option instrument for abnormal gains. While option instrument is designed in such a way that huge profit or gain is possible with a minimum amount of capital, the problem starts when most speculators perceive options more in line with lottery tickets than an investment vehicle. It is observed that a vast majority of option traders casually choose to opt for out of the money options or the ones which have less time to expire. There is nothing wrong in buying an out of the money option or even an option which has got less time to expire. However, to do that consistently without studying the probability of winning can be disastrous in the long run.

In option trading the concept of time decay and probabilities is very important and usually the ones who understand both these concepts well turn out to be successful in the long run. Let’s consider an example: At Nifty 9,500 strike price the call option is trading at Rs 96 while at Nifty 9,700 strike price the call option is trading at Rs 35. Assuming the view on markets is very bullish, chances are most of the traders will opt for the option with strike price of 9,700 where the premium is only Rs 35. In this case the herd mentality is: “Let me take a shot as the maximum loss I will incur is not more than Rs 35.”

This mentality is what leads to losses in the long run. As an option trader, buying out of the money call option should be done only when the trader expects the stock prices to jump immediately and sharply higher. If the trader expects the underlying security to inch upwards slowly and mildly without any spikes, buying out of the money call option may lead to losses even when the underlying security prices are inching up. Options traders must gauge the probability of the option getting in the money at the time of expiry. For that the trader will have to observe the implied volatility, delta values and theta values in detail.

For instance, there is no point in buying call option at Nifty 9,700 even if it is trading at Rs 35 if the probability of the option getting in the money is less than 30 per cent. It is always better to opt for buying a Nifty 9,500 call option with an option price of Rs 96 but with a higher probability of, for example, 80 per cent of being in the money. Given that time decay and probability have a negative effect on the option prices, it is important that the trader realises how in the long run there is a greater chance of making profits consistently by reducing the leverage and buying options with some intrinsic value rather than choosing to always go for out of the money options. 

The movement of the prices of the given option is not always directly correlated to the price movement of the underlying security.

Mistake 3 

Using Complex Strategies 

Sins Option Traders Commit 

Let’s start with the basics. How does option trading differ from trading cash stocks, whether delivery or intraday? In order to trade cash stocks, you need to just think in one dimension, i.e. direction. If your directional view is correct, whether the stock moves up immediately or after a few days or after a few months does not matter since you will get a pay-off.

However, while trading in options one needs to think in three dimensions: direction, time and volatility. If a trader wishes to execute an options trade – whether buy or sell – he needs a view on direction (up, down or flat), time (his view will be effective in how much time) and volatility (will the volatility of the stock increase, decrease or remain the same). Thus, these three factors determine what kind of strategy one uses. It will be different depending on the interplay or outlook of these three factors where direction remains the same.

Sin 1: Misunderstanding leverage. Futures are leveraged products, options doubly so. Then using brokers who allow option buying or selling with lower margins (with associated very high costs) is a sure recipe for disaster. Being so overleveraged might seem awesome given the ROI is correct, but one can also blow up pretty easily on any adverse movement against a trader’s view. And that happens 50 per cent or more of the time.

Sin 2: Not having a clearly defined exit strategy. In a naked option or any option strategy, one needs a clear back-tested view on where the trader should exit – whether in profit or loss. Hoping for the trade when it goes against and holding, or hoping for more and holding when trading at a profit leaves the vital part of exit to guesswork or sheer luck – again, a sure recipe for disaster.

Sin 3: Averaging options when at loss. Averaging does not work, period! If a trader’s option trade is at a loss, his original view has been shown to be wrong by the market. Averaging simply means throwing good money after bad trades.

Sin 4: Not having a money management or position sizing strategy. How much one can lose on a trade i.e. the absolute amount must be fixed when entering a trade. That absolute amount should be a percentage of capital not exceeding maximum 1 per cent of capital at any given trade. It can be lower too if the trader is conservative. Remember the words of hedge fund manager Larry Hite: “To win you need to keep betting, but if you lose all your chips you cannot bet.”

Sin 5: Focussing on the expiration graph. An options pay-off diagram shows the expected pay-off or risk at expiry. But given a change in the three factors outlined in the first point, the pay-off at the middle of the expiry can be totally different. So a trader must be aware on how his position or pay-off will change with a change in the three factors at any point in the expiry. 

Subhadip Nandy, is a Quantitative derivatives trader and founder of quantgym.biz

Time Decay

The concept of time decay is very important when it comes to options trading. Time decay is nothing but a reduction in an option's price caused by the passge of time. Time decay usually accelerates as an option nears its expiration date. 

The beauty of option trading is that it accommodates all types of traders based on their risk profiles. There are opportunities for high-risk traders where the traders can write naked options or buy out of the money call and put options while opportunities also exist for low-risk traders where the trader can simply buy only those options which have the highest probability of winning even if it means the winning amount or percentage gains is not extraordinary but higher than in the cash markets.

At times traders get lost while designing the ‘perfect option trading strategy’ and make it too complex for them to understand the outcome of the strategy. The strategy becomes complex only when the trader has not completely understood the strategy and its ‘pay-off’ correctly. Complex strategy usually involves buying two or more option contracts. To avoid getting into a complex strategy every trader should keep in mind the following steps:

✤ Understand exactly what the objective is before entering the trade.
✤ Calculate and estimate what the maximum possible profits are and the probability of achieving maximum profits.
✤ Check if any adjustment in position will be needed. If yes, when will the adjustment in position be needed and what type of adjustment will be required?
✤ Most importantly, will the trader be able to monitor the positions closely enough to avoid huge losses?

Conclusion

Option trading no doubt introduces the most exciting trading opportunities for traders and investors alike. One of the reasons why option trading is getting popular is the opportunity to book extraordinary gains by deploying minimal capital. However, most traders are not able to consistently book profits and create wealth using options even though the opportunity exists for one and all. There are some common mistakes which lead to poor performance of option traders as highlighted above. Avoiding such pitfalls can give any option trader the required edge.

Traders have to get into details of the option trading mechanics and understand the option to estimate the probability of winning. Probability is the key in option trading and so is time decay. Once any trader gets used to these concepts, nothing can beat the experience of option trading. Also, an important aspect of option trading is ‘focus’. There are so many underlying securities that trade in the Futures and Options section. A trader can do great service to his own self by managing to focus on select top volumemakers rather than hunt for opportunities everywhere in the Futures and Options space.

A trader can always decide to study the options data for liquid indices such as Nifty 50 and the top 10 underlying securities with highest volumes in the options markets. This way the trader will be able to identify better opportunities in a timely manner and the chances of generating profits consistently will increase dramatically. Avoiding common mistakes is paramount and will go a long way in creating wealth for serious traders who intend to generate above average returns on investments. Remember that the secret for winning in option trading is not leverage but calculated risks and calculated probability. There can some good trading ideas and some bad trading ideas. Traders need to learn to differentiate the bad trading first. This will lay the path for a better experience in option trading.