Let’s find out how to trade options…
The first step is to learn as much as you can about options and markets.
There is no way around understanding and learning about things that are complicated. And many a time way beyond the scope of a retail or beginner trader.
I have faced that issue I have paid my price. And then I understood that I need to improve my understanding. I need to learn much more. That is when my trading started turning around.
Once you understand the basics, then you understand different options trading strategies, what market situations you need to apply them in.
What are the pros and cons of a certain strategy? And if at all, the market goes against what you plan for, how you can adjust those strategies and still come out on the winning side or manage your losses in that adverse scenario.
Thirdly, you learn market scenarios to make a list of them in which certain options strategies work. But if you have a list of options, market scenarios and of corresponding options strategies, it will be much easier for you to select the correct strategy for that particular market situation.
And the chances of you succeeding with this particular approach are much higher than you need to develop a framework which will help you identify those particular market situations in live market, with your analysis and your framework, you will be able to identify.
You can say that this is a particular situation where this particular option strategy is suitable. And then you go in and you apply that options strategy in the market. Your chances of success are very, very high.
You can learn all you want to learn about options in a matter of week by reading some books and watching some videos. But to be able to trade them successfully and consistently the best approach is to select not more than two or three options strategies and not more than one or two specific market scenarios which you are going to trade.
First, become master of that and then you expand your market scenario list and the associated options strategy list. Just because you understand an option strategy that does not give you the right to make money from, you need to understand the market situations as well and then be able to apply the appropriate options strategy that is going to make money.
Lastly, you have to be patient because these instruments, options are very, very complicated. The strategies associated with them are complicated. Understanding and developing and identifying and segregating market scenarios in itself has been a difficult task and we have been trying to master it for so long.
So overall, there is a steep learning curve and if you try to jump the intermediate steps, you might get lucky on one or two options trades and then the market will strike back and take more than what it has given. I am very sure if you are a beginner trader and struggling with the trading, as I was a few years earlier, I have faced this scenario more times in my trading where I make a certain amount of money and the market just takes it back.
And the reason is very simple lack of market understanding lack of a reliable sound, logical framework. Those are the first steps. If you take care of those. Well, yeah, then you can move on to these complicated instruments and then make consistent money and reduce your risk and increase your potential reward. All that is possible, but you need to be very, very patient. In the last few years, options selling has become the next glamorous, big thing in the market.
I have seen people with very, very small accounts size telling me that they are options sellers as if that is something to become. Option selling is just one of the strategies in this whole option universe. It’s not the be-all and end-all of becoming a successful trader. Some people have spread this misinformation and small retail traders are paying the price.
Option buying probably costs you the least amount of money. Buying a nice out of the money option will cost you very, very less and will give you an opportunity to make a big amount of money if the market moves well in your favour. But there are certain factors that you need to consider before you go on and buy options in the market.
The first thing is the levels that you expect the markets to reach.
The second point is the amount of time it is likely to take to reach that particular level. Both these things are into the future where the markets will go, how fast will they go there?
All these things are in the future. And I am a firm believer that you cannot predict the future. So answers to these questions can be educated guesses at best. The answer to these two questions needs to be compared with how much time is remaining for the expiry. The strike price you have chosen to take advantage of this particular move.
And lastly, the overall market conditions are they really volatile are wild moves happening in the market or market is just stagnant and caught up in a range and just doing nothing.
You need to be aware of the overall market conditions and when those conditions are likely to change. And if you have answers to all these questions, you will be able to answer this question when you buy options and when not to buy options.
And we are not talking about selling options here. We will talk about it later on when we have a sufficient amount of understanding of this topic. All these concepts may seem complicated and they will start making sense as we move deeper into the series, as more and more videos are published, as I will publish in the series.
So once you understand whether you should buy an option or not buy an option, the next question is whether you should buy and in the money option or an out of the option. Obviously, we discussed our deep in the money options and how they replicate their actual stock options or futures position.
So if you are not sure how long it will take or if you do not have sufficient time left for the market to move and you still want to give yourself a chance that if the market moves, you go for deep in the money option. If you have sufficient time on your side and the likelihood of a big move is very, very high, then you can reduce your cost by going a little bit out of the money.
Out of the Money Options are always cheaper than in the money options and your cost will be low. You can buy more number of options and if the view works out, you stand to make much more than buying a deep in the money option or in the money options.
It will depend on how the markets are panning out. Your understanding of the markets, whether the situations are going to change, whether the volatility increases, you’re going to see directional movements now, whether there will be a breakout or there was a strong move and how we are going to move to consolidation.
All those factors will come in and will help you decide whether you should go for in the money options or out of the money options and the big question, whether you should buy an option or sell an option. More on that soon.
Now, there is another question which is asked by the sceptical traders, the old-timers who still believe in buying and hoarding the stock. And they don’t want to get into options and they will always ask, why are options so dangerous?
Because they have heard about those horror stories where people sold a bunch of options and the market moved drastically, lost all the money blew their accounts all those kinds of things. You need to understand that options are as dangerous as any other instrument in the market, whether it is a stock or a future or whatever.
Whenever it comes to financial instruments, all instruments are equally dangerous, and the amount of danger is directly dependent on how much you understand them. Take an example of stock your friend gives you a tip about a nice penny stock that is going to become a multi gainer.
And you go when you buy that stock and then you realize that six months on stock hasnt moved. In fact, it has started moving lower and then it almost goes to zero and the company goes out of business and the stock is delisted and you lose all the money. So buying a stock, holding it is risky as well. The only difference between a simple stock and these options is the amount of leverage.
If you have ten thousand rupees, you can only buy 10000 worth of stocks. But if you have ten thousand rupees, you can buy multiple times of these options instruments, multiple times of amount of stock with just that 10000 rupees. And that is leverage.
So let’s say you bought a stock worth of one lakh rupees using the ten thousand rupees that is almost ten times leverage. That leverage is a two-edged sword. So it can make you a lot of money in a very short period of time and it can completely ruin your account in the same amount of time.
So be very careful when trading options, but if you understand them well, if you understand the risks and how to manage them, then options become very, very interesting and a very, very viable way of making money in the markets.
Absolutely. If you’re selling options, you’ll be charged a certain margin amount. And if the market just blows out, let’s say you have sold call, you were expecting the market to stay below a certain price, but the market just goes higher.
Some news comes in. I don’t know what, but the market just keeps moving higher, well be beyond your strike price. And if you don’t do anything about that option, you stand to lose a huge amount of money. That has happened with traders.
Traders who have sold options carried them overnight and overnight a bad news comes in. You get a gap down market. People have lost their homes. Forget about their accounts, huge amounts of money because of this kind of indiscriminate trading decisions.
So, yes, you can lose more than you invest in an option, but only if you are selling it and you are not hedging it properly. Similar question is, can you go negative with options? Absolutely. You can go negative with options. And the answer is similar to what I just told you, that if you sell an option but don’t hedge it properly or you don’t understand what the market situations are and the market moves against you by a big amount.
You stand to lose much more than you have invested.
Again, it depends on whether you are an option buyer or you are an option seller. So if you are buying an option, your maximum loss is limited to the premium you have paid.
So you know in our example of NIFTY 12000 strike price, 12000 market price. You bought 12000 calls for 100 rupees. The market does not move higher. Your losses limit limited to 100 rupees into the lot size. For NIFTY lot size is 75. So you lose a maximum of seven thousand five hundred rupees.
But if you sold that option you will receive 100 rupees premium. That is your maximum profit. And if the market starts moving higher and higher and higher, you will lose much more than what you got. That you may receive a hundred rupees, but you can lose much more multiples of that if you don’t do anything about that position.
And why I say in theory is because these events, they are not occurring daily. They are very, very sparsely spaced around. So you won’t get a circuit every month. It happens every few years. And what happens in the meanwhile, traders will lose sight of that.
They will start thinking that nothing bad ever happens and they will just blindly keep selling options and making money on all those times. And then one day the market will just keep moving in one direction and you will employ certain unreliable hedging strategies or you will sell more options and you just compound the mistake and you will end up betting the ranch and losing it.
So you have to be very, very careful of…
We are going to go deep into all these topics very soon, so stay tuned. Thank you for reading this post till the end. And here are suggestions for the next post you should read or video you should watch and I’ll see you in the next one.
Part 1: Options Trading For Beginners Step by Step Guide
Part 3: Is option trading a good idea?