Adopt Best Practices to Make Money in Options

Option trading is often considered lucrative by traders as there is always a chance to book abnormal returns in the short term. Option trading is also popular because it requires less amount of capital. However, majority of investors ignore the most important aspects of option trading and commit some common mistakes on a regular basis, thus making it difficult to make money consistently. Yogesh Supekar introduces the concept of implied volatility while Karan Bhojwani highlights the importance of implied volatility in option trading and shares some of the most popular and useful option trading strategies that can be used by option traders

Option trading gains momentum when the markets become volatile. In fact, increased volatility is a perfect opportunity for option traders to cash in on the price movement and make some quick bucks. However, option trading is not something that will produce positive results without adopting some of the best trading practices. Says Mohit Sharma, an option trader who also believes in momentum trading: “In my initial trading days I use to trade a lot in the option instrument. I realised that in spite of several highly profitable trades I was not making much money. I used to usually buy out of the money options just because they were cheap. The other mistake that I use to do was that I use to buy options when the volatility was very high.”

“After spending several years in the market, I now know that writing options when the volatility is at its peak is better that purchasing options. One of the most important realisations I have had over the years is that trading options without tracking and understanding the implied volatility is a no-win situation. Studying implied volatility is the key to making money in option trading. Almost all of your strategies should be based only after observing the implied volatility.” Implied volatility (IV) is important for retail traders because it is forward looking. IV is different from the historical volatility. IV is not calculated based on the historical data and in fact it tells us what the marketplace is ‘implying’ in terms of volatility of the underlying in the future.

This IV data is calculated based on the price changes in an option. There are several indicators used before adopting a particular option strategy. Implied volatility percentile is one such useful indicator that can be explored by traders to make money while trading in options. Implied volatility percentile is one of the key indicators but often overlooked by many option traders. The whole concept of trading options and selecting the right trading strategies depends on the concept of implied volatility. Mean reversion or reversion to the mean is the theory which suggests that something which has seen a substantial rise or fall would eventually move back or return to its mean.

Based on this theory, traders adopt their trading strategies so that when IV is too low, they prefer to buy the options assuming IV would rise and on other hand, traders prefer to sell when IV is high in anticipation that IV would fall and revert back to its mean. This sounds simple and easy, but it is not so easy in reality. As many a time option traders fail to determine how high is ‘too high’ or how low is ‘too low’ to buy or sell an option. Here’s where the role of IV percentile comes into picture. It provides a solution to the option traders to quantify the implied volatility.

What is IV percentile? It tells you the percentage of days in the past when a stock IV was lower than its current IV. In simple terms, IV percentile data points out the percentage of days with implied volatility closing below the current implied volatility over a given period of time. So, if the stock’s IV percentile is at 90 per cent, it means the current IV is more than 90 per cent of the daily IVs in the stock, which means it is high IV for that stock. Meanwhile, if the IV percentile of a stock is 10 per cent, it means the current IV is higher than 10 per cent of the past values. How might an option trader assess these readings? IV percentile will help traders to make a quick judgement if the current IV is high or low for specific underlying and based on this assessment a trader can formulate whether to do a debit or credit strategy in that particular environment.

Therefore, the next time you decide to formulate an option trading strategy, do look at the IV percentile as a high IV percentile could indicate that options premiums are relative higher and there might be opportunities to use short strategies, while a low IV percentile could indicate that options premium are relatively low, and there might be opportunities to use long options strategies. What is important to note is that IV percentile is a valuable indicator that helps to identify extreme reading and it elevates our edge; it is not something to be thoughtlessly followed. All other factors must be considered before entering into a position.

Interview

Nitish Narang
Founder, Stockmock.in

Knowing the Rules
What are rule-based setups? It means you have predefined rules for your trades that you stick to each day. As is said, “Plan your trades, and then trade your plan.

Example: Nifty Short Straddle Per Leg Stop Loss 40% Entry at 9:57 Daily

Here is the screenshot of the Backtested Results :

Strategy Explanation

What is short straddle? It means selling at the money (ATM) Call and ATM Put together at any given time. What is stop loss (SL)? It means exiting the trade or leg when that goes against you and you start seeing loss. SL is the only factor that is going to save your capital from getting wiped out completely. So never trade without SL. SL 40 per cent per leg means we are saying that if any leg (Call or Put) shows the loss of 40 per cent at any time then exit that leg and let the other leg keep running till end of the day or till it also hits stop loss. So the rules are: Exactly at 9:57:00 sell ATM Call and ATM Put. For example, you sold at Rs 100 each. Now 40 per cent SL means Rs 140 is your stop loss for each leg.

What can be simpler than this setup? Now, finding a good strategy is the first crucial step but guess what the hardest part is? It is maintaining discipline. It is easier said than done. When you are faced with a streak of losses, you start doubting everything and then change the rules. Doing homework to find good strategies and sticking with it demands discipline. Once achieved, your battle is half-won.

Some key concepts to always remember before trading any strategy:

• Stop loss i.e. never trade strategy without SL
• Maximum drawdown
• Slippages n Expectancy
• Back-tested results

Get comfortable with the above concepts and you are good to start. I often say this: Back-testing is a study, and study in any field is a must. When we study back-test there are so many things we encounter while analysing results that they open new ways of thinking, and once we enhance our thought process there are hundreds of routes to follow. Therefore, start with the study.

Kirubakaran Rajendran
Founder www.squareoff.in

Tips for Dealing with Drawdowns

Even though we know about the drawdowns through back test why is it really hard for a trader to sail through a drawdown phase? It is because when the real money is at stake, all sorts of behavioural mistakes happen. We keep asking if this drawdown is temporary or the system has stopped working permanently. A prolonged drawdown damages your conviction and confidence. That’s why we should give importance to time drawdown. You should know how long does your trading strategy stay underwater when the market regime changes. For instance, in the year 2017 most of the intraday trend followers suffered prolonged drawdown mainly due to historical low volatility.

So, when you are designing a trading system, do not just look at returns only; you should check its drawdown and time drawdown. Both are essential. If the back test says 15 per cent drawdown, you should be ready to face two times of that i.e. 30 per cent drawdown when you start trading live. Also check in how many instances the equity remained underwater for longer duration. Follow these ten most important rules to become a successful system trader:

✓  To be a long-term successful trader, you should be okay being a short term loser. Learn to accept the losses.

✓  You can’t be a winner always. Instead of fighting against drawdown, make peace with it, learn to live with it.

✓ Always remember that every trading outcome is random in nature. Most traders at times think “I faced three continuous winning trades, fourth can be a losing trade and hence I am not taking the fourth trade.” No, don’t do that. You can never be sure about the outcome of your next trade.

✓  Never override your trading system. The trading system always wins in the longer run. Let it do its job, do not interfere with it.

✓ There are traders on Twitter who always make profit without any drawdowns. Don’t fool yourself. It’s better to un-follow such handles.

✓  Failures and setbacks are part of life; we are able to live with it, and we know only when we deal with such setbacks that we can come up in life. Similarly, drawdowns are inevitable; it is only when you learn to handle them and deal with them that you can hit the new equity high.

✓  Always doubt your trading system before implementing it not after going live. If a trading system is with small or insignificant drawdowns it is more likely a result of chance, randomness or curve fitting.

✓ Always trade small when you start trading a system. Get used to its daily fluctuations and gradually increase your stake in it.

✓  No matter how high the returns look like, don’t fall for it. Always check how much risk you need to take in order to achieve those returns. If the returns to drawdown ratio is very small, you can avoid it or reduce the leverage and trade it.

✓  Above all, always assume that your biggest drawdown is always in the future. So take a smaller risk with each trade if you want to strive in this business for the long term.

IV percentile is a valuable indicator that helps to identify extreme reading and it elevates our edge; it is not something to be thoughtlessly followed. All other factors must be considered before entering into a position.

Strategies for Option Trading

There are some profitable strategies used in options trading. Many option traders trade options with an objective to become rich overnight. However, we would like to say that there is no shortcut to success and this applies to option trading as well. The aim should be to earn money with consistency and keep the risk under check. In this segment, therefore, we will talk about option strategies (two-leg strategies) which have the potential to provide decent returns by keeping the risk under check. Before we begin it’s important to understand that a trader needs to have a view on the underlying asset before initiating any option strategy. So, let us begin the strategy construction.

Moderately Bullish View : In case a trader is expecting that there would be a moderately bullish view on the underlying stock’s price during the options term, he or she may initiate a Bull Put Spread option strategy. What is Bull Put Spread? A Bull Put Spread strategy is a two-leg option strategy and as the name suggests it is constructed by using only Put options. It involves shorting one Put option with a higher strike price (in-the-money) and buying one Put option with a lower strike price (out-of-the-money) of the same expiration date. Strike selection should be based with a broad view on the stock or index and its winning probability.

Is it a debit or credit spread strategy? It is a credit strategy as sold premium is more than bought premium. Thus, we receive net credit. Here is an example for the construction of this strategy: Let’s say a stock named ABC is trading at Rs 332. We executed a Bull Put Spread by shorting 340 strike price Put (in-the-money) at Rs 16 and subsequently buying (long) 320 strike price Put (out-of-the-money) at Rs 6. The lot size of stock ABC is 1,750 shares. Net credit for this strategy is Rs 10 per share (Rs 16- Rs 6), where Rs 16 is what we have received by selling in-the-money option of 340 strike price and Rs 6 is outflow as we had bought out of the money Put of strike 320.

A trader would realise maximum profit on this strategy when the stock price expires above the Short Put Strike price (340 strike price). Maximum profit potential is limited up to the net premium received. In the above example case, it would be Rs 10 (per share) x 1,750 (lot size) = Rs 17,500. A trader would incur maximum loss in case the stock expires below the Long Put Strike price (320 strike price). Here is the formula to calculate maximum loss: Strike price of Short Put Strike (340) - strike price of Long Put Strike price (320) – net credit received at the time of initiating a trade (10) = Rs 10 x 1,750 (lot size) = Rs 17,500. Break-even point = Strike price of Short Put (340) – net premium received (10) = Rs 330.

Moderately Bearish View : In case a trader has a moderately bearish view in the underlying stock’s price during the options term, he or she may initiate a Bear Call Spread Option strategy. What is Bear Call Spread? A Bear Call Spread strategy is a two-leg strategy and is constructed by buying one out-of-the-money (OTM) call option and selling one in-themoney (ITM) call option of the same underlying asset of the same expiration date. Is it a debit or credit spread strategy? It is a credit strategy as sold premium is more than bought premium. So, we receive a net credit.

Here is an example for the construction of this strategy: Let’s say a stock named XYZ is trading at Rs 7,222. One can execute a Bear Call Spread by buying 7,400 call strike price call at Rs 40 and subsequently selling 7,100 strike price call option at Rs 140. Net credit for this strategy is Rs 100 per share (Rs 140 - Rs 40). The lot size for this stock is 100. Maximum potential profit is limited to the net premium received. Maximum loss in the above example would be the difference between the strike prices i.e. 300 (7,400-7,100) and net credit received is 100 per share. The maximum loss would, therefore, be 200 (300-100) per share. Break-even point = Strike price of short call (7,100) + net premium received (100) = 7,200.

Conclusion

Option trading is as much an art as it is a science. The skill-sets required for successful option trading are the same as required for normal equity trading; however, the technical know-how on how the options work is a must. Best option trading practices should include risk management. At any given point of time, it is important to realise the total exposure and the overall risk of the option strategy. Discipline is the key and the best option trading practices should include detailed research, scouting for opportunities using implied volatility, designing a strategy and sticking to a strategy, setting up realistic goals and designing an exit strategy. While formal education may not be necessary, some sort of technical education helps traders understand how the market works and can be instrumental in trading options successfully. A focus on right indicators along with a disciplined approach and a pre-planned strategy will go a long way in helping option traders’ book profits on a consistent basis.