A lot of Indian retail option traders buy options in the hope of making money, sorry I was wrong actually they buy options in the hope of making a lot of money (unlimited profits).
Here is one real example of how a trader lost more than 40 lakhs buying options looking for that home-run which never happened. Actually home-run never happens because people book profits much earlier and let the losses run.
Unlimited profits is actually a trap. How many of you have actually made even one trade of unlimited profits? I mean what is unlimited profits? Buying an option for 10 and selling it for 100? Has anyone done that? Or you book your profits much before that? Maybe when its up 20% or 30%. So where are unlimited profits? Please do not fall for such a trap.
Unlimited profits is nothing but another name of GREED. And greedy option traders never make money. Ask me, I was one of those greedy traders. But the stock markets took a lot of money from me to make me realize greed is bad in stock markets.
Similarly unlimited loss is also a trap. Do you think an option seller will leave his sold option open if its losing money? No. But lets leave that topic for another article.
However option buyers have an excuse and that is they think option buying is “limited loss unlimited income strategy”. Yes it is. But the problem is they book profits at 10 points and leave the losses open in the hope the trade will reverse. Unfortunately the option expire worthless. All money gone. Where is the profit?
Option buyers have to get 3 things right:
1. Their timing and direction of the stock price,
2. Their view of the movement and how far the stock travels,
3. Time and volatility.
I should have written 6 actually, but that would have scared option buyers. 🙂
Lets discuss them one by one.
1. Their timing and direction of the stock price:
Option buyer timing has to be perfect when they buy options. As soon as they buy a call option, the stock has to go up. If they buy a put option, the stock has to go down for them to make money.
Let me take an example. At the time of writing this article Nifty is at 6050 (a 1.25% up-move from yesterdays close). Now a call buyers view might be that Nifty might move further 20-50 odd points up. He buys a Nifty JUL13 call option strike price 6000 currently at 78. Now what I mean by the timing has to be right is that Nifty has to go up from here from the time he bought the call option. It’s already 3.20 pm – we are ten minutes away from close.
The buyer may have a target of 10 or 20 points and since ATM options generally have a delta of .50, it is assumed that Nifty has to go up 20 points from here for him to make 10 points profit or has to go up 40 points for him to make 20 points. Note that .50 delta means every 1 point move in Nifty will add .50 points in the ATM call. Similarly .50 we be deducted from the ATM call if Nifty moves down.
What do you think are his chances of success. Forget about what the technical analysis says. Just think about a figure of the success rate. 50%? Yes it is and in that case his probability of winning has already reduced by 50%.
So when you are buying options – your timing has to be right – absolutely right. The stock or the index has to move in the direction of your option from the moment you buy until you book profit.
2. Their view of the movement and how far the stock travels:
If a stock is moving up, or going down – chances are it will continue to do so for sometime and then the trend will change. The problem is we don’t know when. Today Nifty went only up, and closed almost at its peak at 6040 (the 6000 call we bought is already at a loss). The point is the option buyer’s view should be correct and it should hold for quite some time for him to book profits. Remember that time is also eating away the premiums of the options bought. His race is against time too. The stock has to move pretty quickly in the direction the buyer predicted, so that he hits the profit.
Unfortunately most of the times their view is right but timing is wrong. They still lose money. For example, you are thinking that Nifty will move up from here and you bought at call. If your target is 10 points your stop-loss should be also 10 points. What if Nifty hits your stop loss and then starts its upwards journey again? Your view of the movement was right, but in the long term not in the short term but you lost anyway because you cannot keep waiting to see your options expire worthless. If they do you will lose all the money you paid as premium. You have to take a stop loss at some point even if your view was right.
Seeing this many option buyers increase their stop loss points to 20 or 30 points. And increase their target to 20 points too. Can you get the idea? The more money they are losing the more money they are putting at risk. Do you think this is a good idea? Well it may work if you buy more time. Explanation is below. However there are no guarantees.
Another example. What if Nifty stays in a tight range for quite a few days? Only 7 calendar days are left for expiry. Time is eating away your premiums almost 10% a day on an average. Even if your view was right, you will have to take a stop loss just because your premiums were melting away.
So your view of how far the stock will travel, and timing both have to be correct to make a profit when buying options. Chances of success? 50%.
Combining 1 and 2. The chances of success of an option buyer is 25%.
3. Time and Volatility:
If the above 2 were not enough, the option buyers have one more major issue – their prediction of the movement has to come within a specified time else the option premium will melt away. Of course especially for call buyers, when the stock moves up, volatility goes down. For call buyers this can be killing.
They will be frustrated to see that their prediction was right, timing was also right, speed was also right but somehow the options worth is not increasing because the volatility is decreasing.
Lets discuss in details. Just like stocks, no one can predict volatility. Jumps in volatility in the range of 3%-10% are quite common. A 5% jump in volatility can bring in significant changes in the price of an option. Volatility is a friend of an option buyer if it increases, but enemy if it decreases. Usually when the market is trending up the volatility decreases. It also decreases if markets remain calm and stagnant. But they can also increase if it goes up especially when predicting gets difficult. However one thing is for sure, when market falls fast, volatility increases, because there is fear in the markets.
The point here is and I think everyone knows it, if volatility decreases the option values also decreases. So your timing may be right, your view may also be right, but if volatility crunches after you have bought an option – chances are you will still be making a loss. How bad is that?
I have myself witnessed many times call option getting reduced in value even after an increase in the stock price. It will be really frustrating to see your option going down in value even after your view was right and the timing excellent.
Now the big question. How many times can you get all of the 3 points correct? Donâ€™t be disappointed. You can, it is not that every time you will fail. But the failures will be more than the winners and therefore you will not be able to make money buying options.
One thing more. Most retail traders buy ATM (at the money) options. In technical sense, ATM options are the costliest. Why? Because they have the most time value. They have zero intrinsic value and therefore all they are buying is time. If the stock does not move – the option will become worthless. If they buy OTM (out of the money) options, the stock has to travel very far and with high speed for OTM buyers to be successful. How many times will they be successful?
Combining 1, 2 and 3 we can see that the chances of option buyer being successful is only 12.5%. Which means they lose money 8 or more times out of 10 times they trade on an average.
So what you should do when you want to buy options?
1. Buy time too: You should give your options enough time to succeed. For example if you give yourself 60 days of time instead of 30 days – you have a lot of time to make a profit. Agreed 60 days options are costlier, but they give you a chance to succeed. However since you have given yourself time you should also now give the options more room to perform. For example a 20-25 point stop loss and a 40-50 point profit booking whichever comes first. Note that the profit points are double than the losses.
2. Buy when volatility is low: Agreed you cannot time volatility, but if you someday see the volatility has droped considerably, you may go ahead and buy options. When volatility will increase you can realize a profit.
3. Donâ€™t be greedy: Keep booking profits at regular intervals or just keep a trailing stop-loss of profits. Don’t get greedy thinking to book profits when the option price will double. They do happen but sadly you don’t know if your option will double or not. You should look at points and book your profit when it arrives.
Final word: You got to take a call. Sometimes buying options is good. For example when you are sure a stock price will move in any direction sharply, in that case selling options is suicidal. In such a situation you should buy call and put options and wait for the price move and book your profits – still if volatility drop you will lose money.
However under normal market conditions – buying options will not make you money in the long run!
Note: If you are tired of buying options and losing money, I advise you to take my course. I do not promise that you will make 100% returns every month or even a year. But I can promise you that 3-5% a month is possible. I will explain to you very conservative strategies. You will know exactly when to enter and when to exit and book profit. For more information read this or contact me.
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