The most common way in which traders lose money is by buying Calls when they think the market is bullish and buying Puts when they think the market is bearish. More often than not, they buy OTM Options. Here is the problem with that:
Suppose NIFTY is at 15800, and you buy Nifty Weekly Call option of Strike 16000, the option will have a premium of around 100 Rs. This means that your option starts making money at 16000. But you start breaking even (if you intend to hold till expiry) only at 16000 + 100 = 16100, as you have to recover the 100 Rs premium you paid for the option. That means your breakeven is 300 points away.
Table of Contents
- Understand the Risks Involved in Options Trading?
- Reducing Your Risk in Trading
Understand the Risks Involved in Options Trading?
When you buy or sell options what are the Options trading risks that you are exposed to? Traders often believe, and erroneously, that buying options is free of risk. Let us say you buy options and lose your premium once it is OK. However, the real Options trading risks can arise even on the buy side if your buy options consistently bomb and eat away a good chunk of your trading capital. Also, when you are the buyer of an option, the time value works against you. That means; even if the price is constant, you keep losing time value and the value of the option keeps going down. But the real risk in options is in writing, so we focus elaborately on the selling side of options risks.
Reducing Your Risk in Trading
For many investors, options are useful tools of risk management. They act as a hedge against a drop in stock prices. For example, if an investor is concerned that the price of their shares in LMN Corporation are about to drop, they can purchase puts that give the right to sell the stock at the strike price, no matter how low the market price drops before expiration. At the cost of the option’s premium, the investor has hedged themselves against losses below the strike price. This type of option practice is also known as hedging with a protective put.
While hedging with options may help manage risk, it’s important to remember that all investments carry some risk. Returns are never guaranteed. Investors who use options to manage risk look for ways to limit potential loss. They may choose to purchase options, since loss is limited to the price paid for the premium. In return, they gain the right to buy or sell the underlying security at an acceptable price. They can also profit from a rise in the value of the option’s premium, if they choose to sell it back to the market rather than exercise it. Since writers of options are sometimes forced into buying or selling stock at an unfavorable price, the risk associated with certain short positions may be higher.
Different option trading strategies
Options trading strategies can be protective like protective puts. Options strategies can also be cost-reducing like covered calls. Options strategies can also be volatile like long straddles and long strangles. Options strategies can also be rangebound in style like short straddles and short strangles. Finally, options strategies can also be moderately bullish or moderately bearish like a bull call spread or a bear put spread respectively.
Benefits of option trading
Options trading have a few interesting benefits. Firstly, they allow you to hedge or protect your risk and define your maximum loss. Secondly, options trading also allows you to take a speculative position in the market by just risking the premium amount. Finally, options trading can also be used for limited risk strategies by combining different options.
Stop your losses fast
Like I just mentioned, losses are easiest to accept when they are small. As they get bigger, it only gets tougher to exit. If trading options with larger than say even 1% of your capital, having a stop loss in place is important. Many retail traders get stuck in this vicious cycle of hope when there is a loss that is too big to accept. Short term or intraday trades turn into long term positions just because of the loss. When you buy options, this decision to hold losing intraday positions overnight only exaggerates the loss. Like I explained before, when you buy options, there is a constant depreciation of time value, and along with it, the premium. Every extra day and weekend that you hold buy option positions significantly erodes the premium.
Suppose Investor B instead sold Investor A a naked put. Then, they might have to buy the stock, if assigned, at a price much higher than market value.
Suppose Investor B sold Investor A a call option without an existing long position. This is the riskiest position for Investor B because if assigned, they must purchase the stock at market price to make delivery on the call. Since market price, theoretically, is infinite in the upward direction, Investor B’s risk is unlimited.