Busting the myths about Options Trading

According to NSE data, brokerages have opened an average of 13 lakh new demat accounts per month since April last year, bringing the overall retail investor number to a record 6.97 million as of May 31 this year, with an Rs.1–2 lakh average Demat account balance. This balance looks worrisome, if one is looking to take leveraged trades by using options.

In recent years, the Indian derivatives market has experienced a significant increase in option trading activity. The F&O segment of the National Stock Exchange (NSE) has a daily turnover of more than 4 lakh crores, with index option activity accounting for more than 80%. On Bank Nifty weekly and Nifty monthly expiry days, the same turnover exceeds 10 lakh crores.

The Options segment has grown in popularity in recent years as a result of its own profile, which sounds similar to playing an addictive video game. Trading activity in this area is constantly increasing since it provides the chance to profit from all types of market conditions, whether bullish, bearish, range bound, or highly volatile.

Let’s start with a basic understanding of what an option is and why it attracts so many people. Aside from the cash market, where equities and indices may be purchased and sold, the exchange also has a futures and options market where these stocks or indices can be bought and sold.

A futures contract is an agreement to purchase or sell an underlying stock or index at a fixed price at a future date, whereas an option is a contract that provides buyers the right, but not the duty, to buy or sell an underlying asset at a certain price on or before a specific date.

Assume that Mr. A purchased 1 lot (50 quantity) of Nifty October futures at 17700 at the start of the October series, and that Mr. A is currently profiting or losing based on its volatility. If it falls to 17400, Mr. A would have lost Rs. 300.

In the second situation, Mr. A purchased 1 batch of 17700 Calls at a cost of Rs. 100. (that is the premium of 17700 Call). Now, if the Nifty falls, Mr. A’s risk is restricted to the premium of Rs. 100 that he paid, but if it rises, Mr. A would profit from the market movement minus the premium of Rs. 100 that he paid to obtain this right of benefit.

Option buyers must pay a premium in order to obtain the right but not the duty, limiting risk in the event of a market drop while increasing profit in the event of a market rise. Because option sellers get this premium, their risk is unrestricted, while their profit is limited to the premium price they receive for this option contract.

Option Buyer’s take:

  • Option buyers just have to pay the premium, thus the cost of obtaining a contract is significantly cheaper than the cost of obtaining a future contract.

Option Seller’s take:

  • They profit from range-bound market movement because if it stays in a range, the premium falls according to the nature of option contracts.

Let’s bust some myths about options trading:

1. Options trading is a zero sum game

Options can, in fact, be utilized as insurance plans. Not only may they be utilized as trading vehicles, but they can also be employed as risk management instruments.

There’s no reason to think that if he/she buys a call option and benefits by selling it at a higher price, the seller incurred a loss equal to his/her profit. The seller might have hedged the bet and profited much more than he/she did.

In hedged options trades, one shouldn’t see anything that resembles a zero-sum game. Others realize it as black and white: if one wins, the other loses. That, however, is an oversimplification.

2. Options are risky

Another widespread misconception about options trading is the risk component. When you first start trading in options, you may come across several novel concepts and methods. However, as you gain experience, you may utilize the arithmetic involved in stock option trading to your advantage and construct a portfolio.

Options trading may be hazardous in terms of risk parameters only if traders do not utilize specified risk trades. The term “naked options” deals with a defined risk by defining position sizing and stop losses. When options aren’t backed by any equities, they’re sold “naked.” As a result, when the stock market swings against the naked option, the risk exposure grows.

3. Buying calls or puts is the only successful strategy to trade options

This is a frequent misunderstanding. While buying calls or puts may be extremely rewarding, it is also a more dangerous strategy to trade. When buying calls or puts, you must be correct in these three conditions: direction of movement, size of movement, and timing of movement.

The underlying has to go in the correct direction, and it needs to do so quickly. You can correctly forecast the direction and amount of the move, but if it occurs after the options have expired, you will lose money. Even if everything goes your way, if Implied Volatility falls (for example, following earnings), you may still lose money.

4. Only Option sellers make money

The truth is that option traders may earn from both buying and selling options. There would be no buyers if only sellers made money, and there would be no market if there were no buyers. Option buying has a distinct advantage in many situations, particularly when the market is volatile, moving, or directional. Premiums have risen dramatically in recent weeks, particularly in weekly expiries.

5. Earning money is easy with options trading

The fact about options trading is that it is hard labor. It takes a lifetime of hard work, dedication, and attention to learn how to trade and invest properly. Not only is studying the foundations a long and difficult process, but you’ll quickly realize that being a student of the markets never stops.

Trading and investing according to your individual risk tolerance, time horizon, financial goals, and personality is the key to discovering and keeping a high degree of success in the markets. This is a critical point. Your primary objective should be to create your own strategy that incorporates all of these factors.

6. Option Trading- Buy and hold strategy is effective

Many traders feel that buy and hold isn’t as effective as it once was. However, because there are always outliers, traders must be proactive in their trade management. This will increase the worth of your assets. You may do this by using options, such as selling cash-covered puts to get lower-cost shares.

Alternatively, covered calls can be used to sell shares at a higher price. Both of these techniques can be used to improve a portfolio. You will find new possible methods as your experience and knowledge of option ideas improves.

7. Options can be traded only in short term

The truth is that the NSE Nifty 50 index has expiring options in 2–3 years. Those are called LEAPS (Long-Term Equity AnticiPation Securities).

Conclusion

Option trading may be done in a variety of ways. Using a variety of diverse options trading techniques, such as straddles, calendars, and iron condors can be applied in options trading.

Buying some inexpensive out of the money options and “hoping” for a large move, is rarely a winning strategy in options trading.

By Aashutosh Chandra (aashutosh.chandra@xumitcapital.com)

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Xumit Capital is a boutique investment advisory firm that deals in equity, global & crypto portfolios and investment migration programs.