Mistakes to Avoid While Trading in Options

Options Trading has been gaining popularity in India. When done right, Options trading can generate significant returns. In fact, the benefits of trading in options is fairly well-known, i.e. it has defined risk, high return potential, and can generate income in even a sideways market.

But Options trading requires thorough research and a clear strategy. And there are certain mistakes that you should definitely steer clear of.

In this article, we will cover:

• What is Options Trading
• Key Terms to Know
• Difference between Options & Futures
• Mistakes to Avoid While Trading in Options

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What is Options Trading

Both Futures and Options fall under the Derivatives trading segment. Derivatives – as the name suggests – is a financial contract that ‘derives’ its value from an underlying asset’s price movement. The assets could range from stocks and commodities to indices.

When you trade in Options, you enter into a contract to buy or sell a specific quantity of an asset, at a later date, and at a pre-determined price. Remember that this is a right, and not an obligation.

Options traders estimate whether the future price of an asset will be higher or lower than its current price, and accordingly enter into the trade. Both parties aim to benefit from the fluctuation in the price of the asset.

By trading in Options, you can hedge and manage your risk, and in the process enjoy potentially higher returns.

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Key Terms to Know

Here is a quick look at some of the key terms you should know, when trading in options

1. Call Option – Gives the trader the right to buy an asset at a specified price and within a specified time-frame
2. Put Option – Gives the trader the right to sell an asset at a specified price and within a specified time-frame
3. Premium – Amount required to exercise the Options trade
4. Strike Price – The price at which the contract will be executed
5. Contract Size – The deliverable quantity of the underlying asset being purchased or sold
6. Expiration Date – The date on which the contract expires i.e. the option to buy or sell has to be exercised before this date
7. Intrinsic Value – It is the difference between the Strike Price and the Current Price of the asset

Difference Between Options & Futures

The workings of Futures and Options may look similar, but they aren’t the same.

Right versus Obligation:

In Futures trading, the contract is obligatory. Options contract, meanwhile, gives the trader the right but not the obligation, to execute the contract. Thus, if the conditions aren’t favourable, the trader can choose not to exercise his / her right to buy or sell.

Payment:

In Futures trading, the trader doesn’t need to pay the full amount upfront. The trader only needs to keep margin money (i.e. a certain percentage of the traded value). This margin is blocked and cannot be used for any other trades. In Options trading, the buyer has to pay a “premium”, while an Options seller has to set aside margin money.

Expiry:

In Futures Trading, the contract cycle could be of one month (near month), two months (next month), and three months (far month). Whereas in Options trading, the contract cycle could be weekly, monthly, and for long-dated options contracts, the expiry could be 9 months to even 3 years.

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Mistakes to Avoid While Trading in Options

Now that we have gone through the basics, let’s look at some of the common mistakes that you should avoid while trading in Options.

#1 Lack of Knowledge & Research

Whether you are trading in equities or derivatives – research and understanding is important in both. Before trading in Options, make sure you understand the various terms, concepts, and trading strategies.

PL organises LIVE market webinars, where our Lead Derivatives Analyst, Shilpa Rout teaches Options trading. You also get a chance to practice these learnings in the LIVE markets. You can register and attend these webinars to learn all about Options trading. Click here to access our research.

#2 Over-leveraging the Positions

Options trading gives you higher exposure by paying a relatively smaller premium. This is called ‘leverage’. This is often mistaken to be a cheaper investment. However, if the underlying asset’s price does not rise or fall as expected, then the leverage could magnify the loss. This means, if you increase your leverage too much, then the losses can be relatively higher.

#3 Buying Far Out of the Money Options

Traders buy far-out-of-the-money options, thinking that it will turn out to be a jackpot trade. Note that the profits may be higher for buying far-out-of-the-money options. But to make these profits, there needs to be a sharp movement in the price of the underlying asset. And the probability of that happening is lower.

#4 Trading Illiquid Options

Liquidity means how quickly something can be bought or sold. Illiquid options have lower Open Interest. Due to this, you may be unable to exit the trade at a fair price. Hence, you should try to choose Options whose underlying assets are liquid.

#5 Relying on a Single Strategy

There are multiple strategies while trading in Options, ranging from covered call, straddle, strangle, bull call spread, and so on. So, don’t rely on a single strategy for all your trades. Based on the market condition, price movement, and other factors, you should try to implement different strategies. It is also important to ensure that the strategy you choose aligns with your outlook.

#6 Choosing the Wrong Expiry

Choosing the right expiry is as important as the strategy. Put in place a checklist, which can help you on this front. Some of the questions that this checklist could include are: how long will it take for the price to reach the level you expect, is there enough liquidity to support the trade, impact of corporate actions or results on the trade, etc.

#7 Underestimating the Power of the Greeks.

To make profits through Options trading, you also need to understand the power of Greeks. Greeks describe various risk parameters of Options trading and help in studying the finer aspects of the price movement. For example, Delta measures Options price sensitivity to changes in the price of an underlying asset. Meanwhile, Gamma measures the Options’ price sensitivity to changes in Delta. Also, time value, measured by Theta, is also extremely important for Options buyers.

So, these are some of the most common mistakes that you should avoid, while trading in Options.

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