Options Trading : A Double-Edged Sword For The Ignorant!!

Option trading is as popular as equity trading. In spite of the popularity of option trading, there are many traders who consider option trading as too risky and too complicated. The thing with option trading is that it is for all seasons, i.e., there is one or other strategy for every market condition. While there are opportunities galore in every market condition, there is also greater room to make mistakes while trading in options. The benefits of trading options come with the risk of making mistakes while trading in options. Once the common mistakes are taken care of, there can be nothing more exciting than trading options in the markets.

Common mistakes traders make in option trading :-
Option trading can be used to generate small returns consistently, hedge risks and also to take advantage of the opportunity presented by volatile market conditions. However, the several mistakes that a trader makes while trading in options makes us believe it to be an unprofitable proposition. Here are some of the common mistakes that traders make while trading in options:- 

What are Iron Condor Strategy ?
The iron condor strategy is a limited risk strategy employed by option traders. It is a non-directional option trading strategy with a large probability of earning a small limited profit when the underlying security is considered to have low volatility. The strategy includes a combination of a bull put spread and a bear call spread.

The strategy involves Selling 1 OTM put, Buying 1 OTM put (Lower Strike), selling 1 OTM call and buying 1 OTM call (Higher Strike).

In this strategy, the maximum profit = Net premium received - Commissions paid. Max profit is achieved when the price of underlying is in between strike prices of the short put and the short call, as at this point the option expires worthless.

1) Focusing on OTM options

Majority of option traders indulge in trading out of the money (OTM) calls or put options only because these are cheaper. Most investors buy shares considering its share price and ignore the fundamentals of the company. Investors make similar mistakes while choosing an option. The traders often think it is a good deal to buy options that are trading at a cheaper rate, however traders must understand that like in equity trading, there are no free lunches in option trading as well. The options are priced in such a way that there is no room for free lunches. Very few traders understand that the option premium decays with time and, therefore, the profitability of the strategy not only depends on the underlying stock's price going up or down, but also on how fast it goes up or down. To make profits consistently by buying OTM options, traders have to assess the probability of the underlying asset exceeding the strike price before expiry.

2) Traders are often not flexible with their options strategy

It is seen that traders stick to a single strategy in all market conditions. It must be realised by traders that options are extremely flexible and can be used in all market conditions and that not all options strategies work in all market conditions. When the overall market is calm and less volatile along with the underlying asset, buying OTM options may not produce the desired result.

The probability of making profits on buying OTM options increases in volatile markets. The appropriate strategy to adopt in a flattish market can be to write covered options. This strategy of covered options would require investors to already have a position in the underlying stock and write options against it. More complex strategies such as iron condors can generate profits if the prices of the underlying don’t move much.

3) Most traders don’t have an exit plan

Exit plan is essential in not only option trading, but in all market positions. Answers to following questions should be ready with the trader before he/she enters a trade: -

1.What is the exact amount of profit one is looking at?
2.What if the market moves in a direction opposite to your expectation?
3.How long are you going to hold the option – till expiry?
4.If the underlying asset goes in opposite direction, are you going to exit the option early before it becomes worthless and reduce the loss?
5.Often, answers to these questions are not ready with the investors, and hence, they end up mismanaging the option trading position, thereby incurring higher losses. Realistic targets should be set and a strategy to minimise the risk should be in place.

4) Ignoring major events
Most of the times, traders are too short-sighted and they do not pay enough attention to the major events happening around the globe that can shake the markets. Major events such as the US Fed rate announcement, RBI interest rate policy announcement, inflation data, GDP data, quarterly earnings, winning large contracts, etc. are all important factors that can impact stock prices in the short term, at least. It is possible that a trader, looking at the prevailing flattish market condition, deploys an option strategy that works best if the underlying stock prices remain flat. However, the trader completely ignores that the volatility may increase in the underlying due to occurrence of any of the event or multiple events as mentioned above. Such ignorance can lead to huge losses. An options trader has to understand what is happening in the markets and keep track of global and local events that can impact stock prices. Thus, monitoring the economic calendar and earnings calendar is essential even for the options trader.

5) Ignoring consistent small gains in favour of huge gains
Most traders are lured by the potential to make huge profit and pay no heed to smaller gains even when these can be regular in nature. The trader focuses only on those trades that yield 100% or more returns in the very short term. This behaviour does not allow traders to book regular small profits per trade and leads to potential losses in the overall options trading.

Small profits of 2 to 5 per cent per trade on a regular basis can generate almost 20 to 25 per cent in a month. Instead, traders would bet on only those trades that yield 25 per cent (per trade), the probability of which is lower compared to the gains of 2 to 5 per cent.

A trader must understand that making consistent small profits is much more doable and easier than making one huge profit. These small profits, if extrapolated on an annualised basis, can be impressive and look massive

6) Not choosing the right expiration

The expiration for any option purchase should depend on the outlook of the trader on the markets. Option trader should check the following before determining the expiry :-

1. Should one hold the option through earnings announcement or any other corporate event?

2. Is there enough liquidity to support the trade for the chosen expiration?

Most of the time, traders err in choosing the expiry date only to see that while the underlying asset has moved in the desired direction, the option has not grown in premium. Buying options with too long expiry date can be a costly mistake.

7) The position size is often incorrect

Most traders make the mistake of either betting too much in any option trade or betting too less. As a result of greed and fear, the position size goes wrong for majority of the option traders. Very few traders practice a common method of position sizing, such as

"risking a percentage of total capital value, viz., 1%, 2%, 5%, etc."

Ideally the position size should be such that in case the underlying asset moves in the opposite direction, the trader should not lose his or her sleep, but it should be large enough to make meaningful contribution to the portfolio.

Option Strategies To Be Adopted In Current Market Situation

As a trader, one of the most important aspects for being profitable in the stock markets is to understand the trend of the markets. As the saying goes, 'Trend is your friend', hence, it is important to be with the trend to make profits in the markets. The trend is generally defined as the direction in which the prices of stocks or benchmark indices are headed over time. 

Trend can be categorised into three major types: 

Uptrend 
Downtrend 
Sideways trend 

Most of the traders are comfortable or find it easy to trade when the markets have a clear directional trend. But one of the most difficult yet inevitable market conditions for traders is the notorious sideways market. A market moving sideways presents some of the most frustrating periods in the life of a trader, as it has been observed that if the markets are not moving much, traders often get into an unwanted position in anticipation of seeing things happen, only to end up with a regret. 

It is also a well-known adage that markets spend a majority of the time in sideways patterns. If you think about it logically, how can the market continuously trend up or down all the time? A constant move up or down is not sustainable. In the Indian markets, we observed that in the November series, the markets oscillated majority of time in a range. However, the bulls engineered a scintillating rally in the last leg, but the fact remains that for the most part of the November F&O series, the markets traded in a range. Now the question that arises is, what should a trader do when he gets into a situation where the markets are trading in a sideways phase? Can a trader make profits during such a phase? 

A trader can adopt options trading strategies where traders can not only safeguard their gains, but they can also increase their profit potential. Option strategies allow traders to profit from movements in the underlying assets. 

Following are some basic option strategies which can be used in a sideways market condition: 

Short Strangle Strategy: 
Construction of Short Strangle Strategy? A short strangle strategy is constructed by selling Out of the Money Call (OTM) option and simultaneously selling Out of the Money Put option. Both options have the same underlying stock and the same expiration date, but they have different strike prices. 

When to initiate this strategy? 
Traders may initiate this strategy when they believe that the underlying security will not move substantially in either direction. This strategy can also be used by traders when the implied volatility goes abnormally high and the premiums of the Call and Put options may be overvalued. 

Maximum reward using this strategy? 
Maximum reward that can be realised under the short strangle strategy is limited to the total premium received by selling the options. 

Loss Potential? 
Potential loss is unlimited if the stock price rises or falls substantially. 

Theta for Short Strangle option trading: 
Time decay is the biggest factor which benefits the short strangle option strategy if all other things remain the same. If the underlying stock does not move much and stays between the upper and lower wings of the short strangle, the trader can make good profit from this strategy. 

Vega for Short Strangle: 
Vega estimates how much an option price changes as the level of volatility changes, while other factors remain unchanged. A short strangle has a negative vega. This means when the volatility rises and all other things remain the same, option price and strangle price tend to rise and, therefore, short strangle starts to lose money. 


Short Straddle Strategy: 
Construction of Short Straddle Strategy A short straddle strategy is constructed by selling At The Money (ATM) call and At The Money put option of the same underlying asset with the same expiry. 

When to initiate this strategy? A short straddle option strategy can be initiated when a trader believes that the underlying security is likely to move in a narrow range near the strike price. Traders can adopt this strategy when the implied volatility goes abnormally high and the option premiums are considered to be overvalued. 

Maximum Reward using this Strategy? 
Maximum potential reward is limited to the total premium received by selling the options under the short straddle option strategy. 

Loss Potential? 
Potential loss is unlimited if the stock price rises or falls substantially. 

Theta for short Straddle Option Trading: 
Time erosion or time decay is the biggest beneficiary for the short straddle option trade. If the underlying stock does not move much, and other things remain constant, it is this income which the option trader is betting his luck on. It is most effective when the underlying price expires at and around the ATM strike price. 

Vega for Short Straddle: Similar to the short strangle, the short straddle has a negative vega. Therefore, the trader should initiate short straddle when the volatility is high and it is expected to drop. 

Traders need to understand that all that glitters is not gold. It is important to understand that these strategies carry theoretically unlimited risk and hence, traders need to have a proper exit plan and also they need to understand the impact of option Greeks.

Sacchitanand Uttekar 
DVP – Technical (Equity), Tradebulls Securities 

In directionless markets, is writing call options a good strategy? 
Writing options is mostly considered by professional traders who understand the options instruments in depth, especially the decaying element of premiums with respect to time. When it comes to any call options writing strategy, it completely depends on the preceding move which has commenced and the exhausting of its ongoing momentum. Directionless market could be a stage of consolidation; hence it mostly depends on the next expected direction, which plays a key role whether the stock/index could resume its primary direction and how soon. Usually, it has been observed that the deep out-of-the-money options during such phases provide decent premiums which could be capitalized by adopting such theme of writing call options once the trend momentum starts exhausting and a directionless bias comes into play for a brief period. Usually, writing a call option against an existing holding is far better way to approach, or even resorting to a credit spread like bear call spread to play safe are ideal ways to participate in such scenarios. 

In the current market scenario, going up to May elections, what option strategies can be adopted profitably? 
Events mean uncertainty and when it comes to most uncertain events, election results are the most complex and hence attract severe volatility swings not only ahead but during the unfolding of the event too. Option premiums come very handy while gauging the expectations of such events, especially the magnitude of volatility which could be anticipated. Implied volatility ahead of the event remains a barometer for gauging the overall impact. While a simple exercise of adding both call and put premiums of proximal strikes (ITM, ATM and OTM) near the current action and monitoring them thoroughly can provide you with the expected swing range to be witnessed during the event. Once these aspects are aligned, one can consider either going long volatility or shorting it, depending on the nature of the scenario developing then. Once the event outcome hits the public domain, there is always a defusing impact observed when the volumes witness a sharp drop which one should be aware while planning exits.

Who should trade in options and why? 
Anyone and everyone can trade options. Speculators love them due to their low risk capital and buying options and other combinations are always appreciated by them. While inventory holders or moneyholders could capitalize on intention by selling options against their existing holding to optimize their cost and garner upon the time value within their existing trade. Hedger, by buying options, could add some degree of protection towards their risk on hands. Hence, options as an instrument provides the liberty to flex one's expectations and optimize one's payoff in a better way.

Benefits of trading in options:-

1. Lower capital requirement 
2. Option is an opportunity to leverage 
3. Customising your strategy 
4. Investors can combine options with stock investing 
5. Option trading helps you understand the market mood 
6. Insurance and risk management 
7. Limited risk and unlimited profit potential

Conclusion :-
No other financial instrument is as flexible as options are. It is a great tool to trade in all market conditions. However, when not used properly, options can be disastrous. An option trader also needs to use different strategies and always be prepared for potential changes in the market conditions. It is important to know when to exit trades and inculcate the habit of booking profits on a consistent basis. It is important that the trader deploys a strategy that matches his outlook.

Not to forget that trading in options needs to take into consideration market variables, both before and after the trade. Develop an option trading plan and stick to it.