Beware, options gurus’ spiel is subject to market risk

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Free advice on how to execute complex trades have made derivatives trading seem like quick way to get rich, and comes at a time of falling brokerage fees, and rising retail participation in futures and options (F&O), especially on the options side. Individual investors accounted for one-third the share in index options turnover at the end of fiscal 2022. Six years ago, the share was just 22%.

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Risky road

Experts said retail investors expecting quick gains from options trading after following success stories on social media may find reality quite different.

“On social media, it is very easy to get carried away, thinking that one can also make money, as a lot of people are making money through options, which isn’t really true,” said Nithin Kamath, founder of discount broker Zerodha, country’s largest broker in terms of active clients.

“Less than 1% of traders end up making more money than fixed deposit (FD) returns, actively trading the markets, which includes options,” he said.

Several social media influencers often share screenshots of their profits, but there is no way of verifying whether these are genuine or not. Also, these screenshots may not capture the long-term performance or the performance of traders’ strategies as a whole. Some traders may have an opposing trade as a hedging strategy to limit the downside, which may see losses when the other leg of trade profits and vice-versa.

Risk of buying options

Abid Hassan, co-founder and chief executive of options trading platform Sensibull, said there are different demographics of investors that are new to trading and want to try it out.

“There are well-funded investors who come with 30-40 lakh of margin money, or at least 10 lakh, and want to try out options. For them, sophisticated long-term strategies are possible. They can manage risks better. Then there is the aspirational crowd, which wants to make money quickly and desperately. Some of them just want to double their investment, want to buy a car, or even address genuine problems like clearing an education loan, meeting the medical expenses of a family member, etc. They are more susceptible to taking a lot more risks than they can even afford. As a result, they often blow up,” says Hassan.

Trade fair

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Trade fair

Several retail investors end up buying options as it requires less capital.

However, there is a high probability of loss when it comes to option buying.

Retail investors are especially attracted to out-of-money options, as the premium on these contracts is cheap.

Out-of-money contracts are contracts that are far away from the market price of the underlying.

“But the lure of making quick and outsized gains on these contracts is what gets them attracted,” said Anish Teli, founder of QED Capital Advisors.

When such options are bought with a near-term expiry, they carry minimal time value, as the probability is stacked against it; of the market price reaching that contract’s strike price in the weekly expiry. It is possible but less probable.

Option contracts can gain through two routes. One is through time value, and the other is its intrinsic value (IV). This is nothing but the spread between the market price of the underlying instrument (Nifty indices or stock) and the option contract’s strike price. As the gap closes, the IV increases and vice-versa.

Sell options? But there is a catch

You can also do the reverse, i.e. option writing or option selling.

Unlike the option buyer, the passage of time can work to the advantage of the option seller. This is because the seller gets to collect the time-value premiums, which erode as contracts near the expiry. The caveat is that the underlying price should be far from the strike price.

However, a much larger capital is needed to sell options, from 1 lakh and above, depending upon the number of lots, the expiry date, the strike price, the premium, etc. Even more to manage the risks better (more on that later).

According to Kamath of Zerodha, traders with low capital should not venture into options trading, whether buying or selling, as they won’t be able to do money management with small capital.

“With options, even if you are selling them, there are always chances of losses, which one should be wary of when getting into such trades. You can have 11 months of returns, and then one month can wipe off all those profits in one sweep. So, money management is critical when trading options, which is only possible if one has a large capital.”

While margin money can absorb losses when selling options, losses can be more than margin money and cause much large liability if there is extreme market volatility.

Remember, the option buyer can only lose the premium he pays, but the losses theoretically are unlimited for the option seller.

Managing high and low emotions

Trading options can lead to a lot of emotional volatility, and that’s why money management is important, which is only possible with large capital.

“Especially in options buying, it is like a lottery ticket. Once in a while, when you have a winning trade, you need to stay with it. But if you only have a small capital, you would be tempted to exit quickly and book profits. But a trader with large capital would not mind keeping a small percentage of his portfolio exposed. He can afford to take the risk and stay with the trade,” points out Kamath.

“The right way to approach options buying is not to take more than 1-2% exposure of one’s portfolio, and when selling (writing an option), not to take more than 10-15% exposure of a portfolio,” he adds.

With options, traders can use multiple strategies such as bull-call spread, bear-call spread, bull-put spread, and bear-put spread.

Experts said retail investors, instead of going with such strategies, gravitate towards the simplest and most popular ones.

“There are several strategies available, even on social media and other platforms, which can reduce the risks. Now, there is more awareness and much easier access to information. But to trade such strategies, at least 3-5 lakh of capital is needed, if not more,” says Mumbai-based Aniket Nerkar, who uses algos to create trading strategies for institutional clients as well as broking prop book clients.

Steep learning curve

Chart trading is what retail investors are often attracted to. But Nerkar said options trading is not as simple.

Sharing his own story, he says that initially, he used to follow this approach and made several losses.

“I used to trade on the basis of narratives, market commentary, news flow, and events. Only later, when I started using quant-based strategies and learnt more about pricing models, such as the Black-Scholes model, I gained more insights. I started developing programs and back-tested them, and that is when I started understanding options better,” he said.

“I traded for prop book of a boutique broking house, where I could implement my strategies and test them,” he adds.

Several social media finfluencers also offer courses, but you might need to develop skills and gain more knowledge to get better at options and manage the high risks that come with it.

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