Trading in options (the right to buy or sell without an obligation) looks quite simple; at least if you are a buyer.
You buy the option by paying a premium.
If you are right, you make a hefty profit and if you are wrong, you just lose the premium. If you have traded options, you will realize that it is really not that simple. Globally, option buyers tend to lose money because selling options entails unlimited losses.
Here are five mistakes that options traders often make. Of course, we also tell you how to avoid these mistakes.
Buying out-of-the-money options because they are cheap
Suppose the stock is quoting at ₹200 and the 1-month call option on 300-strike is available at 50 paisa premium. You may believe that the risk in this call option is very low However, the option premium is low because it is actually worth nothing. The probability of the stock gaining 50% in less than a month is remote. The low premium reflects what it is worth. The argument that loss is small is really not a strong one. After all, you are into options trading to make more money, not to lose less.
Trading options without an exit plan
Whether you buy options or sell options, you must have an exit plan. This includes setting a stop loss for exit, a profit booking target as well as macro triggers when you will exit your position.
Let us explain that one!
For example, if you are holding a call option of an NBFC stock and if the expectation is that RBI will hike interest rates, then it’s better to exit the position to avoid risking a loss. Similarly, if you are sitting on a small loss or profit very close to expiry, it is a good idea to book the profit/loss than to risk time decay in options.
Jumping into stock options before index options
Just as stocks are riskier than the index, stock options are also riskier than index options. An index option like Nifty option is more broad-based and hence the option value is less vulnerable to specific factors. Also, index options like the ones on the Nifty are more liquid compared to most stock options.
Not using stop losses when buying or selling options
Why do we need stop-losses in options trading? When you sell options, the reason to use a stop loss when you sell options is straight forward. Your losses can be unlimited so stop losses are a must. But why put stop losses in option buying when losses are limited to premium anyway? There are two reasons for this. First, when you buy options, time value works against you. When you are likely to lose money on the option, might as well reduce the losses. Second, ATM and ITM options are relatively expensive and stop losses can help you cut losses in unpredictable markets.
Good to know
Time decay refers to the erosion of an option’s value as it approaches the date of expiry is called time decay. Time value is the difference between the current value of an asset and its value after a specified period. For example, a fixed deposit having current value of Rs 1 lakh will be worth 5% more after a year. Thus, in this case, the time value is 5/100 x 100,000 = Rs 5,000.
Getting into complex options strategies
In most trading scenarios, the simplest options strategies work the best. Traders often get into complex strategies with multiple legs like condors, collars, etc. When you get into an options strategy with 3 or 4 legs, you are looking at double the number of executions for closure of positions. That can substantially add to your transaction cost, statutory cost and opportunity costs. Also, when strategies become too complex, you are not sure whether you are net long or net short in the market. To the extent possible keep option trading simple.
With most stock options moving to mandatory delivery, holding of options positions in the last week may become very expensive. Hence, traders must trade options into the expiry week with caution
Source - UPS
Team RYR&Co.
