The charm of options has long attracted traders. Talking about using IV, or gamma, makes one stand apart during peer discussions. While the perception of complexity and risk keeps common investors at bay, those very traits attract a section of traders, who are confident that they can reap the benefits of faster moves and lower prices of options when compared to their equity or index counterparts. Plus, the boost to the ego by way of being able to strategize for all types of market uncertainties. Let us look at the common approaches that investors take while trading in options.
| What traders usually do with options | Potential Gains | Hidden risks |
| Trade naked positions intraday. | High profit potential than combination of options. Investment not locked up. | Higher loss potential. Intraday volatility in options may affect proper entry/exit. |
| Hold naked positions overnight. | Potential for surprise gains. | Potential for huge loss. Some options may lose value drastically which could remain worthless till expiry. |
| Exit before expiry. | Free up investment. Ability to reduce losses, or book profits if trend reverses. | Expected profit at expiry would be foregone. Some strategies turn into profit as expiry approaches. |
| Several strategies at the same time. | Better positioned if market trend uncertain. | Higher investment, higher chance of value erosion if market remain less volatile. Difficulty in profitable exit due to lack of clarity. |
| Buy low premium options. | Initial investment low. Potential for huge losses in a range bound market. | Potential for huge losses in a trending market. Also, options at all strikes do not move with the same speed. |
| Enter and exit as per pre defined option strategy | Risk & Reward more or less limited to those known at the time of entry. | Investment locked up, usually until expiry. |
| Adding or removing positions after entry. | Possibility of maximising profits/reducing losses if done correctly. | Investment/Margin requirement rises. Potential for much bigger losses than that estimated at strategy’s entry. |
| Take positions on the same day of event. | Better clarity on several factors influencing the event. | Higher premium. Higher risk of losing option value after the event. |
| Take positions on the day before event. | Investment locked up for lesser number of days. | High premium. Even if event is as expected, strategy may show losses immediately as high priced premium may see decline in value. |
| Take positions many days before event. | Lower premium – Lower investment. | Higher uncertainty regarding outcome of event. Investment locked up for longer period. |
| Take positions after event. | More clarity on what to expect. | Volatile. Even if event is as expected, strategy may show losses immediately as high priced premium may see decline in value. |
In short, when you invest in options, you can end up with a can of worms or a bag of jewels, depending on what you do or not do, and when you do. Options are still in the traders’ domain and where FIIs are very active, but it is still alien to normal equity investors. Rightfully so. But to the end that option’s expiry is linked to the corresponding equity’s price, there is a whole lot of signals that options give for a stock investor. But that is a topic for another issue.
By Anand James