The derivative Segment contributes to more than 97% of daily turnover in the Indian market with options making up a significant part.
With market awareness among investors growing, there has been a jump in retail participation in derivative segments like options trading.
The key reason is high potential returns and the requirement of low margin, however, there is high risk involved with options trading.
Options trading without knowledge is a game of chance; most new investors lose money in options. Before diving into the options trade, it’s essential to become familiar with the basics.
(1) Funds required: Options have a very small shelf life mostly a month hence one should not utilize the full amount at any given point. It would be advisable to allocate around 5-10% of the total capital for a particular trade.
(2) Evaluate option trade: As a general rule, traders should decide how much they’re willing to risk i.e. there should be an exit plan. One needs to choose the upside exit point and downside exit point in advance. Trading with a plan helps one establish more successful patterns of trading and keeps your worries more in check.
(3) Gain knowledge: One must try to get familiar with some of the commonly used jargon in options and their meanings.
This will help not only help in fetching maximum benefits from options trading but also can decide upon the right strategy and market timing. It is possible to learn as you go along, increasing both your knowledge and experience at the same time.
(4) Avoid trading in illiquid stocks: Liquidity is very important as it allows one to get in and out of trade more easily.
The most liquid stocks are usually those with higher volumes.
Thinly traded stocks tend to be unpredictable and are extremely speculative, so one should avoid them, if possible.
(5) Define holding period: Time decay plays an important role in the pricing of the options. Each passing day reduces the value of your options. Hence, one needs to also cover the position on time irrespective of whether the position is in profit or loss.
The key is knowing when to take a profit and when to take a loss.
Apart from these, one should also avoid excessive leverage and averaging of position.
Like stock trading, options trading involves buying and selling options either call or put. Buying options requires a smaller financial investment with limited risk i.e. up to the premium paid while as an options seller, one takes a contrarian view of the market.
The risk assumed when selling options are unlimited means losses can be more than the original investment if the underlying stock price significantly falls or goes to zero.
Some important rules to follow while buying or selling options are:-
1. Don’t buy deep-out-of-the-money (OTM) options just because it is cheap.
2. Time works against the buyer of the option and in favour of the seller of the option. Hence, closer to expiry it is not a very good idea to buy options.
3. Volatility is one of the essential factors to determine the value of an option. So it’s generally advised to buy options when market volatility is expected to increase and sell options when volatility is expected to decrease.
4. Ahead of major events or key geopolitical risks it is always better to be on the buy options rather than to sell options.
5. Keep booking profits at regular intervals or just keep a trailing stop-loss of profits.
Options trading has the potential to generate multifold returns if practised correctly. One must dedicate valuable time to learning and educating oneself on approaches that work best.
(The author of this article is Head Equity Strategy, Broking and Distribution, Motilal Oswal Financial Services)
Disclaimer: The views and recommendations given in this article are those of the analyst. These do not represent the views of MintGenie.