Top 10 Mistakes when trading cheap options and how to avoid them

Top 10 Mistakes when trading cheap options and how to avoid them

Investing ₹25,000 to trade in the Reliance Options instead of ₹6 lakhs to trade in Reliance Industries shares in the cash market. Sign me up! I'm all for making the most out of the available resources. Even though I have to give up bonus shares and dividends, I will still reap the benefit of leverage. Profit is calculated in a similar way as in the cash segment and F&O segment. So, options market, here I come.

But while trading make sure to avoid these mistakes so as to safeguard your capital. Remember that money saved is money earned. 

  • #10 Not using stop-losses

Make it a habit of using stop-losses on every order. It is right there, you just need to input the amount. This makes sure that you will have manage the risk and get a timely exit from the position should there be a massive upswing or downswing that is causing you a loss.

  • #9 Trading in illiquid Options

Cheap stock options are not always liquid. You will find it difficult to square off your position even when there is an opportunity to book your profit as the bid-offer gap might be wide and you may not get the correct market price to exit. So make sure that the option is liquid before you consider taking a position.

  • #8 Selecting incorrect expiry

In the Indian markets, Index options have weekly and monthly expiry. So select the expiry first and then the strike price at which you want to take a position. Current expiry contracts are usually the most traded and hence it will suit you well to stick to these rather than venture into subsequent expiry contracts.

  • #7 Incorrect position sizing

Position sizing refers to that amount which you are investing in any stock or trade. As previously mentioned, options are leveraged products so they can very easily wipe out your entire capital. 

Let us consider the same example of Reliance Industries, where you have bought a call options contract worth 6 lakhs by deploying only ₹25,000. The advantage here is that if the stock moves higher, your percentage return will be high. On the flip side, if the stock moves lower, you will incur a maximum loss of ₹25,000. But remember that this ₹25,000 is 100% of your capital. This means, if this position moves against you, you can lose your entire capital.This is why, in any stock or trade, we should always take a position such that, if it goes against us, our portfolio is not hit hard and we do not suffer a major loss. 

  • #6 Misunderstanding volatility

Volatility risk refers to the breadth of the trading range between the high and low price levels at which an option has traded. The bigger the range, the greater the risk. For short-term traders, higher volatility means greater profit potential in a short space of time, but it also means greater volatility risk. Options, by their very nature, are highly volatile instruments. It is best to trade options as a part of your overall portfolio strategy and moderate the volatility risk. 

  • #5 Misunderstanding leverage 

Options are leveraged products, they allow you to trade without paying the full contract value. As explained earlier, they can severely dent your capital if not used wisely. While buying options can wipe out 100% of your capital, selling options brings the risk of potentially unlimited losses. Thus, traders should consider trading in options strategies to manage the leverage better. 

  • #4 Not factoring in upcoming events

Financial markets are affected by all the events in the real world e.g. hike in prices of petroleum products due to the Russian invasion of Ukraine or change in RBI monetary policy. These events are not always predictable. But they do have an effect. So watch out for these, like a pirate watching out for the eye of the storm.

  • #3 Having no exit plan

Markets are volatile. Having an exit plan is not limited to just stop losses but also profits. Know your exit points even before you enter into the position. This helps you to make informed decisions.

  • #2 Not checking PCR before buying

PCR stands for Put Call Ratio. This is an important contrarian indicator. It helps the trader to understand whether a recent rise or fall in the stock market is climatic or not and to take contrarian trading decisions based on that. As a rule of thumb, higher PCR indicates the time to sell and a lower PCR indicates the time to buy. This should be used in tandem with other derivative indicators to make informed decisions.

  • #1 Buying far out of the money options

Some option buyers prefer to buy far out of the money options. This is because these options are cheaper. But these carry a risk that if there is no big movement in your stock, you will not make profit in this option. This option will slowly become zero and you might lose your entire capital. A prudent strategy will be to buy slightly out-of-the-money options or even at-the-money options closer to the expiry. 

Since you stuck around long enough to know the top 10 mistakes, here is a bonus mistake to avoid: 

  • Investing without knowing your risk appetite

Your Risk Appetite determines where you lie on the spectrum of risk averse to risk taker. You can determine this by simply asking yourself how much losses you can bear on your trades. Once you know this, only execute those trades that are in tandem with your risk appetite. This will make you more confident and help in the decision making process.

Well that was all from our side, hope you keep these option trading rules in mind when you take a position.