How to go about trading in options?

In recent times, India’s derivatives market has attracted a lot of retail interest and the turnover has increased sharply. But understanding the complex world of derivatives, especially options, is not easy for novices. Portfolio sounded out some traders to see how they go about trading in options.

Understand the pay-off

Most beginners start their option trading careers by adopting the plain vanilla call option or put options of stocks or indices. Even though it is fun buying such options and waiting to make huge profits like in a mini-lottery ticket, it is like gambling as there is the risk of losing the premium paid.

If you are an option seller, the risk will be unlimited. Apart from a plain vanilla call option or a put option, there are about 28 options strategies that involve a combination of calls and puts. These options strategies are categorised into bullish, bearish, neutral and volatility strategies.

SANDEEP PRABHUDESAI, IIM-A graduate

Sandeep Prabhudesai, an IIM-Ahmedabad graduate, who has about 16 years of experience in options trading says, “Beginners should first familiarise themselves with pay-off profiles (visual representation of the risk-reward of the strategy), understanding the Greeks and the concepts of implied volatility. For option theory, “Varsity by Zerodha” is a good start.”

The losses for the buyer of an option are limited, but the profits are potentially unlimited. For a writer (seller), the pay-off is exactly the opposite. His profits are limited to the option premium, though his losses are potentially unlimited. The pay-off profile varies from one strategy to another.

BALAJEE RAMACHANDRAN, A programmer

The option Greeks

Balajee Ramachandran, a programmer who started derivatives trading with Zerodha recently, stresses the importance of implied volatility. He says, “Beginners should always check implied volatility before buying. Understand the option Greeks like theta and vega. They really do matter. Use out-of-the-money options only for intraday bets.” Out-of-the money options are cheaper than in-the-money options.

Implied volatility is the estimated volatility of a stock or index based on which the option premium moves. This is a vital component in options pricing. Trading success can be increased by being on the right side of implied volatility changes.

It is also important to understand delta, gamma, vega and theta, which are collectively known as the Greeks. These terms offer a system to measure the different factors that affect the price of an option’s price, such as price changes in the underlying asset, changes in implied volatility and time value decay of the option.

Delta, for instance, is used to gauge the probability of the option price expiring in the money. Without understanding Greeks, it will be very difficult to trade in options, experienced traders say. Beginners can make use of advanced software available on the internet to calculate the option Greeks of an index or stock.

The preferred strategies

Prabhudesai says, “I mainly trade delta-neutral option strategies which imply not taking a directional view on the market. There are multiple things to analyse before taking on an option trade — for option selling strategies, one needs to check what the current IV (implied volatility) is relative to its history, standard deviation of the underlying and the Greeks of the strategy. The pay-off has to be stress tested and, finally, liquidity in the option is very important.”

Most options traders prefer to trade in index options as they provide more liquidity and are less volatile compared to stock options. For instance, last Thursday, to buy a near call option of 10,750 in the Nifty index, one had to pay a premium of ₹9,300 on a lot size of 75. On the other hand, to buy a near call option of ₹250 in SBI, one has to outlay ₹22,500 plus brokerage on a lot size of 3000.

SALEESH KV, An options trader

Saleesh KV who has about 10 years of experience in trading says, “Index options are better to trade because of the liquidity and lower investment requirement than stock options. Stock options are good to have a short position on, but we need more investment to write the option. So, in terms of return, index options are better.” On the best options strategies for beginners, he said, “Straddle and strangle are best during the big events days.”

P R SUNDAR, An active options trader

P R Sundar, after being a mathematics teacher for 20 years, is now an active options trader with 10 years of experience in the field. He says, “A buyer wants a strong move in the underlying, so that his option will be profitable, whereas an option seller wants a moderate movement in the underlying.

Stocks tend to move aggressively while indices, being a collation of stocks, tend to move moderately. So if you are an option buyer, you should go for stocks and, if you are an option seller, you should opt for indices. Being an option seller, I play with indices most of the time.”

He adds, “Beginners should start with strategies such as iron condor, butterfly and calendar spread where the risks are predefined.

Over a period of time, when they become confident of judging the market direction and get the know of how to manage risk, they can venture into other strategies like ratio spreads, short straddle, and so on.”

Prabhudesai concludes by saying, “A beginner should practice prudent asset allocation and strict risk management, and can start off with strangles or iron condors which are among the most basic strategies.

Option selling strategies require a lot of screen time and should ideally by pursued by full-time traders.”