5 common mistakes retail traders make while buying options

Here are 5 common mistakes that retail traders make while buying options:

1. Buying options without considering leverage – When trading derivatives, If I were asked about just the one thing to put most of my emphasis on, it would be leverage. Fact remains that most newbies don’t appreciate that options are a leveraged product. Consider this example – Nifty is trading at 18000, lot size is 50 so underlying value is 9 lacs. Say a retail trader has an account size of 1L and buys 4 lots of ATM call options of Nifty i.e. 18000 call options at 150 Rs a piece. That’s about 30k in premium or about 30% of the account size. It won’t even take a 2% gap down open for that option to get halved the next day. Before they even realize, 15k is wiped out and that’s 15% of trading capital. All it takes is 3 such trades to find yourself into a 50% loss. There are many ways to size your position in options buying but a very simple way is to look at the max loss as a percentage of overall capital in an adverse case and accordingly size the position. A dirty hack is to not buy options worth more than 10% of the account size.
2. Trading options without understanding of options greeks – Most of the new traders that start options trading do so without any understanding of options greeks. For them, if the market goes up, call prices go up and put prices go down and vice-versa. But, it’s not as simple as that. Option pricing will primarily have three components – direction (or delta), volatility (vega), time to expiry (theta). One might be right in direction but still lose money as they might not have priced in the volatility and time aspects of options. If one learns options greeks and pays enough emphasis on options greeks before taking an options trade, one would find out options structures that are better trades.
3. Buying far OTM options – This is one of the common mistakes most people make. While buying options, they will buy far OTM options because of the premiums they have to pay and the net amount they have to pay. Say Nifty is trading at 17800 and one has a bullish view, buying a 18100 call option in a weekly expiry for 15-20 Rs is a big no-no. You might get an exit at Rs 30 occasionally but more often than not, the premium paid for far OTM options would go to 0.
4. Buying naked options just ahead of an event – Options trading is highly speculative, the most common reason to buy options is out of speculation on the direction of the underlying. There are events like earnings release of a company, RBI monetary policy decision, budget, etc around which it’s a common practice amongst retail traders to buy options ahead of the event in a hope for a larger move in their direction and making quick money. Around these events, the implied volatility (IV) of options goes up due to uncertainty of the outcome of the event and that results in options prices being higher than usual. Once the event is over, IV drops resulting in options pricing going down. While you might be right in picking direction, the IV drop may hurt you more. Ex – declared results on 12th of Jan post market. It closed at 1070 and the ATM call option of 1070 closed at Rs. 22. Next day, it closed higher at 1077 but the same ATM call option closed at Rs.14 despite the fact that the underlying traded higher. IVs of HCL Tech options went down by a massive 30% that resulted in such a steep decline in options pricing.
5. Buying OTM puts options too close to expiry on a massive down day – When you see a major down day in index (Nifty and Bank Nifty), the IVs usually go through the roof. I am talking about a 3-5% fall in indices like we saw on Friday, 27th of Jan. On these days, most people anticipate a further downfall the following day and buy OTM/far OTM puts options in weekly expiry. This is usually a mistake because one really needs a large follow up move the next day for those puts to continue gaining the value. If there’s no to little follow up, the IVs will cool off resulting in reduction in options premiums. If one wants to do bearish options structure on such days, one can look at initiating puts calendar spreads or credit call ratio spreads.

(The author, Ashish Gupta, is a Derivative Trader)

(Disclaimer: Recommendations, suggestions, views and opinions given by the experts are their own. These do not represent the views of The Economic Times)