Trading in options – the naked truth!

What has happened in recent past that has turned the pitch for the option writers? Higher volatility.

July 23, 2020 1:25 IST | India Infoline News Service
Making $1,000,000 from trading naked call and put options happens only to one in a million, the others just go home naked. – Pg. 56, The Thoughtful Investor – tweeted by Shri Basant Maheshwari (renowned investor)

The social media is abuzz with stories of how one retail customer has lost his life’s savings because he traded options. In my earlier blog, I had mentioned that trading in options is best left to seasoned traders. This is an expensive lesson to learn.

First, let us understand the options trade that is often recommended on WhatsApp, Twitter, YouTube, and various social media. You will come across claims about self-proclaimed ‘experts’ who will trick you into believing that they make 2-4% every month by trading options, which translates to 24-48% per annum. This is a very tempting return for anyone – newbie or seasoned. What is the trade? It is simple – you write out of money Call and Put options on Nifty, Bank Nifty, or individual stocks. When you write an option at a particular strike, effectively you are taking a bet that your strike price will not be hit, and you will eat the option premium for free. Let us take a real-life example. Assume, Nifty is around 11,000 levels. You write a Call at 11,500 and Put at 10,500. Effectively you take a bet that Nifty will be range-bound between 10,500 and 11,500. For writing the Call and Put, you need to provide margin to broker/ exchange. That is your invested capital and you get a premium. In a real market, you can easily input these figures on a spreadsheet and calculate returns. If you do not know how to calculate this on a spreadsheet, then my sincere advice is please do not write options.

In a normal month, you do not expect markets to go up or down by 2% monthly. So, in a normal expiry, you will make money by writing out of money options. Even if it falls and breaches 2% on one side, you are somewhat hedged or protected by the position on the other side. The key word is here is “normal”. When markets are volatile, they gyrate up and down wildly and in such a market you will lose big time. If you are writing calls and puts on individual stocks – then you are playing with even bigger risks.

How many of the terms used in the above para are you comfortable with? Call, Put, Strike, Margin, out of money. I am not using Greek terms like delta, theta, vega – those sound very impressive.

Let us refresh the basic definitions from Investopedia. A Call option gives the holder the right to buy a stock and a Put option gives the holder the right to sell a stock. An OTM or out of money Call option will have a strike price that is higher than the market price of the underlying asset while an OTM Put option has a strike price that is lower than the market price of the underlying asset. Writing an option refers to an investment contract in which a fee, or premium, is paid to the writer in exchange for the right to buy or sell shares at a future price and date.
What has happened in recent past that has turned the pitch for the option writers? Higher volatility. The markets and stock prices did not restrict themselves to the old pattern of trading ranges. Prices went higher than your strike price causing you not only losses but also requiring you to instantly cough up higher margins. And the inexperienced trader does not have the guts or mind-set to cut losses and change the strikes to recover. Many a times, they do not have ability to cough up additional margin forcing the broker to liquidate their positions.

As in most cases, the urge to make higher returns ends in a disaster. Some of the victims then complain against their broker to the stock exchanges and SEBI claiming ignorance and often media prefers to blame it more on the broker. No one really questions the retail investors as to why they traded in options when they did not know the alpha, beta, and gamma of options.
The reasons can be summarised in two points:
  1. Greed: Everyone wants to make higher returns. This is universal and there is nothing exchanges, or regulators can do about basic human instinct. Only thing that can be done is educate and make people financially literate.
  2. Comparison trap – There is nothing more frustrating than a friend getting rich, is a quote I have read in an investment classic. You get carried away because someone else is making money easily. You forget your risk appetite and wealth and end up making the wrong trades.
My advice to retail investors is as follows:
  1. Know your risk appetite
  2. Invest in what you know
  3. Do not leverage and trade
  4. Avoid comparison trap
  5. Remember – to make higher returns you have to take higher risk
I will end with an anecdote on what I mean by risk appetite. My school friend sent me a WhatsApp message saying he wants to invest in the stock market and is willing to take some risk. Since I knew him from childhood, I asked him a simple question – can he handle a loss. He promptly replied with a No and clarified that he seeks capital protection. His knowledge from WhatsApp university makes him believe that people make 48% with capital protection by trading options strategies from home during lock-down.

My advice to my friend was if he cannot risk a loss then how can he invest in equities, where however smart you are, there is always a possibility of getting hit by a loss? Unless you invest in a portfolio of stocks and are willing to hold for five years at least, there is always a probability of capital loss.  

I will quote the punter who wrote many years ago in his Punter’s Diary – the man who earns 48% pa with capital protection is not going to share his secrets with the world in a hurry. Keep this in mind when you get the next WhatsApp message.

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