The most successful students I see at Online Trading Academy have knowledge of multiple asset classes and also tend to trade more than one of them. When I ask my students in class, “How many of you trade options?” I usually get several hands raised. However, when I ask how many of them are profitable in trading them, most of those hands go down.
In courses I teach for relationship managers and brokers, I also ask how many of their clients are trading options successfully. To my amazement, I have not found too many profitable options traders in India. This made me look further into the strategies being employed by those traders to see if there is something they are doing wrong and if I could offer a solution.
One such mistake that novice traders make in the Indian option markets is that they try to trade deep out of the money options in order to buy cheap premium. This strategy is often referred to as a lottery ticket as the payouts can be great, but the odds of winning are extremely slim. When trading, we want consistent wins in any market we trade. Most successful traders became that way from winning on a regular basis and not risking poor odds to try and make a big win.
Let’s examine that “lottery ticket” trade and compare it to one that has a higher probability of making money. As of this writing, the Nifty has retreated from the 7700 price level. A trader who wanted to take advantage of the potential bearish drop could buy puts. They would profit from a drop in price as well as an increase in volatility by doing this. On the date I am writing this article, the open interest looked like this:
7600 puts = 53,78,800
7500 puts = 57,86,300
7300 puts = 53,67,300
Looking at the high open interest, it appears that many traders are buying their lottery tickets at a strike price of 7300 on the Nifty. But is this the smartest thing to do? Most traders buy this option because of the low premium cost. Looking at the different options, the cost to buy the 7300 put was only Rs. 590.00 (there are 50 shares per contract).
This is a lot cheaper than the 7600 puts (Rs. 3295) or the 7500 puts (Rs. 1900). But is it the best trade? Most option traders ignore the Greeks in trading. The Greeks are measurements of risk in options trading. They can also be used to gauge potential profitability in the trade. Assuming the Nifty is currently trading at 7650 if the Nifty were to move to 7500 at the expiration of 28th August, the trader who bought the 7300 put would profit about Rs. 450 (Rs. 3 per point move in the Nifty). Not bad for an initial investment of only Rs. 590. But wait, holding to expiration would also cost you time value. You would lose about Rs. 33 per day in time value and that would erase all of your profits in the trade!
Buying the 7500 put costs more, but the larger Delta compensates for the loss in time value. The same movement in the Nifty profits Rs. 900, (Rs. 6 per point move in the Nifty), a nice gain for a Rs. 1900 investment. Buy after time has eroded there is no value left as the option expires worthless.
The last trader who bought the 7600 put had to pay the most but gets to participate more in the movement of the Nifty. They receive Rs. 18.35 for every point the Nifty falls. This translates into a gain of about Rs. 1,37,625. There is also time decay but the delta made up for it. Even when time erodes they are left with a gain! The 7600 put finishes with an intrinsic value of 100 points or Rs. 5000 per contract. The extra amount you had to pay at the entry to the trade increased your chances for success in that trade. I think of it as a deposit to make more money in the movement of the Nifty. That 151% gain is a lot better than taking a risk on a cheap option only to make nothing!
There are a lot of things to learn about trading options. Fortunately there is a solution. Come join us at Online Trading Academy next month for our options course and learn how to trade them properly. Trade smart, it’s speculation with a high probability of success when done right.