Options are one of the most versatile trading instruments. Or at least what they say! Unlike stock, Options cost less and provide enough leverage to trade with limited risk. Despite this most traders lose in Options trading. Did you know that globally; around 80-85% of the traders who buy Options tend to lose money? You may say that it is only the premium but that’s not the point. Some people believe that trading in Options would be as easy as trading in equities. But, even losing premium can demoralize the professional traders. In this article, we will try to understand why most traders or Options buyers lose in Options trading. In doing so, we will discuss some common mistakes that traders commit that will help you understand this.
But, before that let’s take briefly on how Options work.
How do Options work?
In Options trading, the Options buyers have rights and Options sellers have obligations. Just to be clear, there are two kinds of Options: calls and puts – And the Options buyer has the right to buy (call) or sell (put) the futures contract at a specific period of time until the expiration. The price at which an underlying stock can be bought or sold is called the strike price.
So, when someone gets the Option, he/she gets the right, not an obligation. In Options trading, the Options buyers are usually small traders while the Options sellers are large institutions. Small traders who dreamt of getting rich overnight tend to trade in Options and attract towards Options which tend to be fully prices and deep Out-of-the-money (OTM) Options. As a result, time works against the buyers and in favours of sellers.
4 Reasons Why Options Buyers Tend to Lose Money in the Markets
Here we’re going to discuss the common mistakes which are as follows:
- Buying Deep OTM Options – It is one of the common mistakes that most Options traders often do while trading in Options. As we were discussing earlier the attractiveness of deep out-of-the-money Options which is completely hollow. The reason for falling for OTM Options is the low premium. But, you may not be familiar – but the premium is low because the possibility of reaching the level is low. For example, if SBI is currently quoting at Rs 290, the 300 Option may be available at Rs 6 but the Rs 330 call may be available at 1.50. It doesn’t mean that 330 call Option is cheap. It is quoting 1.50 because the probability of reaching that level is very low. So, deep OTM Options are just like penny stocks with low price-to-earnings (P/E) ratios. On top of that in OTM Option, the overall value of the Option is time value which works against you.
- Holding too Close to Expiry – This is one very common mistake which most Options buyers often do in holding option too close to expiry. It is one of the trading tips which all traders must remember at all time – Exit the profit if you are getting a good price in return. In Options trading, you will eventually find out that the loss of time value becomes very rapid when the date of expiry is nearby, in the last few days. This time value is a decaying asset which meets zero by expiry So, marks the words, never hold the Option too close to expiry.
- Not Using Stop-Loss – You must be thinking, are we kidding? Well, we are not! Because you may think that stop loss is for trading in equities in the stock market and better serve intraday or positional traders but truth is, even Options buyers needed to stop losses to protect their losses. To best understand this, let’s assume you bought Company XYZ’s 300 call options at an OTM premium of Rs 6. With just one seven days to go, you don’t see any possibility of XYZ crossing that Currently, the option is now quoting Rs 3. So, the question here is, should you hold till expiry or save Rs 3? Well, the smart move will be to save Rs 3 and square off the position. Think about it! When you have the chance to save your losses why should you bear the full premium loss? A smart Option buyer considers its all options and makes a smart move accordingly. If you keep trading with the mindset of saving the losses then it can make a lot of difference in your profits and losses. In such a scenario, you can use the stop-loss to prevent your losses.
- Not Strategize the Option Trade – Although the options are simple products it can be combined to create limited loss strategies. For example, one can create a Strangle by buying a higher strike price call option and a lower strike price put option. In that manner, you can make money even from the volatility in the market.
Hope, you find this article helpful. Nevertheless, if you have any query or would like to add something then don’t forget to mention in the comment section below.
Note: All information & data provided in this article is for the educational purpose as well as to give general information on the finance & economy, not to provide any professional advice or service. Views & opinions are not biased against the company and do not affect any official policy or any other agency, an organization within the content.