How you can avoid the fate of most retail option traders
Summary
- In India, 90% of retail traders lose money in options markets. Unlike stock trading, options require complex strategies and precise timing, benefiting informed traders and hedge funds
Would you invest in something with only a 10% chance of success? Welcome to the options market, where 90% of retail traders lose money, according to a study by the market regulator, documenting a surge in derivatives market volumes.
The issue is so dire that the Securities and Exchange Board of India (Sebi) is trying its best to stop investors from participating in this casino. Potential measures include a substantial increase in lot sizes. Over time, this may become a market for deep-pocketed investors, those who can afford to take some big risks.
So, why do retail traders usually lose money trading options? Why does that not happen with stocks? Well, it’s because stocks are simple, relative to options. Here’s a tried and tested stock market strategy: buy a diversified index fund and hold on for at least five years. You’re very likely to make a profit. Hold on for ten years, and it is almost guaranteed profit.
Perhaps with some careful analysis, you could do better than an index fund. But it’s easy to at least match the market return with minimal effort on your part.
Also Read: How India turned into a trading nation
But who wants to wait that long? A big allure of trading options is the possibility of making money fast. The most liquid options expire in one month or less. Thus, there are ample opportunities to make profit every day. Unfortunately, making money trading options is anything but easy.
Complexity of options trading
When it comes to options, there is no simple profitable strategy. Options are orders of magnitude more complex than stocks. For a single underlying asset, there are call options, put options, a variety of strike prices, and different maturities. For example, at any given time, you have hundreds of options you could buy or sell for one single underlying asset. Where do you start?
Suppose, you expect a stock to rise. You must decide whether to buy a call option or sell a put option. Next, you need to pick the strike price. And finally, you need to pick the maturity. And even if you’re correct about the stock going up, there’s no guarantee you’ll make a profit. Part of what makes options tricky is that in addition to getting the direction right, you have to get the timing right, too.
Now, we’ve established that options are complex. But with complexity comes opportunity. While retail traders are losing money, hedge funds are making a killing. Consider the recent case of US-based Jane Street, and their one billion dollar profit from an Indian options strategy. They’re accusing former employees of taking jobs at another fund called Millenium and implementing the same strategy there.
To make money trading options, you have to be an informed trader. To benefit from the complexity, you need to be smarter than the rest. Getting there is a long road.
Understanding the basics
Let’s start with the basics. A call option gives you the right, but not the obligation, to buy the underlying asset (for example, stock) at the strike price, on or before expiry. Call values go up when the stock price goes up. Calls are worthless if the stock price ends up below the strike price at expiry. A put option gives you the right, but not the obligation, to sell the underlying asset (e.g. stock) at the strike price, on or before expiry. Put values go up when the stock price goes down. Puts are worthless if the stock price ends up above the strike price at expiry.
This is why timing is so important. The stock must move in the right direction before the option expires. The major benefit of buying an option is its limited risk. You pay a premium upfront to buy an option. If the stock price moves in the wrong direction, you never lose more than the premium you paid.
Also Read: Drowning in debt at 32, confessions of a failed options trader
The best analogy for understanding options contracts is insurance. When you buy insurance, you pay a premium upfront. The insurance company pays you only if some condition is triggered. For example, if it’s health insurance, you get paid if you get sick, and do not get paid if you stay healthy. Of course, when it comes to health insurance, we’d prefer to stay healthy even if it means losing money on the insurance contract. This is because we don’t buy health insurance to profit financially.
On the other hand, the insurance company wants to profit. They set the premium so that they collect more from all their customers than they end up paying out in claims. This is their objective, and this is exactly what happens. How does this translate into options? Well, the first step for an investor is to work out the fair value of the option. In the insurance context, fair value is the premium that would result in the insurance company making neither a profit nor a loss.
Most health insurance premiums are priced a little above their fair value. This means that on average, the insurance company makes money for each transaction, and the customer loses money. Now, this is not an argument against buying insurance. In fact, it’s a small price to pay to get rid of a big financial risk.
Buy a call or sell a put?
In the F&O market, sometimes an option might trade above its fair value, and sometimes below. Let’s return to the example of expecting a stock to increase. Should you buy a call or sell a put? Here’s where the fair value becomes important. If the options are trading above their fair values, you’re better off selling a put. In the opposite scenario, you’re better off buying a call. If the option price is close to its fair value, you’re better off buying a call, because that carries much less risk than selling a put.
This is just a small flavour of the questions you might consider when trading options. There are hundreds of different option strategies, each tailored to a specific situation.
If you think a stock will rise, but not too much, buy a call spread. A call spread involves buying one call and selling another call with a higher strike.
If you think a stock isn’t going to move at all, sell a straddle, which involves buying a call and a put with the same strike.
Most retail traders don’t bother with option strategies, further compounding their losses. They simply trade naked options – buying or selling a single option. Relative to an option spread, this adds substantial risk. In many cases, this extra risk doesn’t justify the extra upside. If you want to make consistent profits while managing the risk, you must find the right strategy for the right situation.
How do you know if trading options are right for you? Does the complexity of strategies sound exciting? Do you want to actively trade, and don’t mind a bit of stress? Are you good at math? Do you want to learn the ins and outs of what these profitable hedge funds do in the options market?
The typical options trader and equity investor look quite different. The equity investor likes the idea of learning how a firm’s business works. Or how its management operates. Or what its plans for growth are. And whether it has a durable competitive edge. The options trader likes to build mathematical models to forecast volatility. The option trader makes many trades and gains a statistical edge over time. He or she is a lot like a Bridge or Rummy player. Which one are you?
Note: The purpose of this article is to share interesting charts, data points and thought-provoking options. It is NOT a recommendation. If you wish to consider an investment, you are strongly encouraged to consult your advisor. This article is for strictly educative purposes only.
Asad Dossani is an assistant professor of finance at Colorado State University. His research covers derivatives, forecasting, monetary policy, currencies, and commodities. He has a PhD in Economics. He has previously worked as a research analyst at Equitymaster, and as a financial analyst at Deutsche Bank.
Disclosure: The writer or his dependents do not hold any of the assets discussed in here as per Sebi guidelines.