The allure, the mystic odds, mammoth single day swings and darn cheap investment prices attract the most intelligent and not so intelligent to trade options from all corners of our country. On first sight, we see investment amounts as low as a few thousand rupees to control (theoretically) large sums of money, they move 20% – 40% in a single day – “What if I could make money too?” you think to yourself.
Today, we’ll cover 8 things you absolutely need to know before you invest in options. The leverages and swings can make or break a trader, with gains of 100% or the possibility of the option expiring worthless on expiry day.
1. Cheap out of the money options
Out of the money options are priced much lower than at-the-money options. I know a trader who purchased a deep out of the money call option and despite the underlying moving up 1% on that day, his call option actually declined. If you do not know how options are priced, you should keep in mind that trading in the money options or at the money options has more liquidity and better chance at success. Perhaps the best times to trade out of the money options are if you are writing them or you are buying them because of a merger announcement or a big event like the union budget or election results.
Summary: Buy only in the money options/at the money options (for naked traders)
2. Learn Option Writing
When buying a put or a call option; you need to be right on direction as well as timeframe (must happen many days before option expiry) or else you lose money. When writing options you can gain if you are correct in deciding direction, time value is on your side. Theoretically your risk is unlimited and profit pre defined, however if you manage your positions the situation of an extravagant loss does not arise.
3. Manage Risk – Don’t Go Broke
Do not, and I repeat – Do not think of investing a large portion of your capital in a single options trade. If the reward of a naked option is 40%, the risks are also pretty high, sometimes 20%-30% & even 100% if it expires worthless. All traders should manage risk, if in stocks you risk no more than 1% on a single trade then you should risk the same amount in options as well. Price moves are very wild and must be normalised by investing small trade amounts to mitigate the possibility of huge losses. Option prices can go to zero on expiry day.
4. Option Charts
Do not trade the option chart, you must trade the underlying price because that is your first contact information in the market. News, fundamentals, indicators are first reflected in price.
Also, there is nothing written in stone when trading the markets, I know traders who successfully trade option charts – however I think for a newbie it may amount to some serious loss of hair – stick to the basics and you will maintain sanity as well as a healthy ledger balance.
When I started out with options, it was a refreshing new world filled with new theoretical price models. When I finally got down to a beautiful trading strategy on a reliance Infrastructure, I found out that the number of contracts traded per day were so low that it produced a large bid/ask spread. That is your first clue to low liquidity option chain contracts. Make sure you trade in a series that has enough liquidity so you can get the best price on entry and exit, markets need liquidity to be efficiently priced.
Summary: You need to trade option contracts that have a tight bid/ask spread or you could lose a huge portion on just entering and exiting, illiquid contracts should NEVER be traded.
The last 7 days to expiry, the value of options which are out of the money will deteriorate severely. This means if you are holding Reliance OTM Calls and there are say 7 days to expiry, you should consider exiting your position with immediate effect because the time value of your contract will deteriorate very fast. As an example on Monday 26th May 2014, with only 3 days to expiry a nifty call option OTM contract fell 45%.
Summary: Do not hold naked OTM calls/puts with few days left to expiry. They will expire to 0 on expiry day if current prices do not reach strike prices.
7. Vega – The Volatility Expert
The market has a personality, it is a beat by itself. It senses danger, volatility and personifies mass hysteria and panic selling. Efficiency is when many traders analyse the market to put on traders, it destroys any opportunities left to exploit.
You see, when there is a big announcement to take place like election results, earning announcements or a M&A deal, the market will add a premium to the existing contracts to ‘price in’ that volatility. Those ‘extra’ rupees you pay to buy an options contract is called the Vega, which is over and above the intrinsic value.
Now suppose you bought a call option at Rs 30, the market is already expecting a earnings announcement, after the announcement let’s say that the underlying stock did not move because the announcement was at par with expectations – The call option you bought will lose value because the volatility was just shot down. In the real world, price will generally move – and If it does move up your calls will make money and you will never know that you had a vega risk in the trade. This point is just to caution you that big events are priced in option contracts
an example of volatility imploding is with the use of the VIX index which plummeted after the 16th May election results announcements – take a look my trader friend:
8. Pick A Direction – Get a Method
If you trade naked, or using spreads where you primarily buy options (I am not talking about delta nutral strategies which do not look at direction but other factors) then you need to find a method to trade with. The Newton Method which is on Trade Academy teaches you that, there are also other countless methods you can use to gauge trend direction. Options are instruments that rely on the underlying – it is vital for trend followers to find a way to gauge which way the stocks are most likely to move to put on a trade.