Buying options looks like a very lucrative deal to new stock market traders. Options have the capability to give massive swings & can give multifold returns a lot easier compared to stock trading. It is also attractive to new traders because it doesn’t require high capital to buy options (unlike buying futures). However, most option buyers lose money in the long run. And this is by design!
Option buying – example
First let’s understand how option buying works. Let’s take an example to understand a typical trading scenario. Ram is a stock market trader who analysed the Reliance Industries stock chart. His analysis tells him that Reliance Industries (CMP Rs. 2600) is bullish and there is a high possibility for the stock to rise to Rs. 2800. Ram has a total capital of Rs. 1 Lakh. There are two ways in which Ram can capitalise on his analysis.
Ram can buy the Reliance Industries stock and sell it later for a profit. He can buy 38 shares using his capital of Rs. 1 Lakh. If the stock rises to Rs. 2800, he can sell his stocks to make a profit of Rs. 7600 providing him a 7.6% return on his investment. However, Ram comes up with a better plan to make higher returns. Instead of simply buying the stock using his capital, he decided to buy CALL options for Reliance Industries. Ram bought the Rs. 2700 CALL option for Reliance Industries with the expiry of April at a premium of Rs. 51.50.
Using his options strategy, Ram was able to buy a CALL option of 7 lots (1750 shares) instead of the measly 38 shares using his capital of Rs. 1 Lakh. If the stock price of Reliance ends up rising to Rs. 2800, he could sell his CALL option for Rs. 100 (CALL option given him the ‘option’ to buy 7 lots of Reliance stocks at Rs. 2700 & sell them at the market price i.e. Rs. 2800). Ram could make a profit of almost 100% (from Rs. 51.5 to Rs. 100) which will turn his capital from Rs. 1 Lakh to Rs. 2 Lakh. This return is surely a lot better than the measly 7.6% return which he was making by trading Reliance stocks.
Outcome of option buying
It turns out that Ram’s analysis was successful! Reliance Industries stock started slowly rising in the upcoming trading days. But when Ram looked at his trading position, he found out that he was not making any significant money. His CALL option was still stuck at Rs. 50-55 range. As the date of the expiry came close, he found out that he was not making any profit on his CALL option. Instead he was around 30% down on his trading position! Ram closed his trading position and his capital of Rs. 1 Lakh reduced to Rs. 70,000 even though his study was accurate because Reliance industries ended up touching Rs. 2800 by mid of May (not end of April when the CALL option expires). So, what went wrong? Why did Ram lose money even though his analysis was accurate?
Ram lost his money simply because buying options have a very high probability of losing money. He was able to predict the rise of the stock accurately but he failed to predict the speed of the rise of stock price.
Why do most option buyers lose money?
Most option traders lose money simply because of probability. Suppose you are bullish on a stock (like Ram) and decide to buy CALL options for that stock. Here are the 5 possibilities which can happen in the short term.
- Stock rises rapidly – You make a lot of money
- Stock rises slowly – You lose money due to time decay
- Stock gets stuck in a range – You lose money due to time decay
- Stock falls slowly – You lose money rapidly
- Stock falls sharply – You lose money rapidly
It is quite clear that there is a very high probability of losing money when buying options. In fact, you can lose money in option buying even when your analysis is accurate!
There are some other reasons why option buyers lose money.
- Usage of stop-loss is extremely difficult in option buying. Unlike a stock, where a clear stop-loss can be defined, options do not have a clear stop-loss definition because your returns are not directly dependent on the stock itself. Lack of stop-loss causes most traders to lose more money than they should! To learn more about why stop-loss should always be used by traders, visit this article!
- If the stock moves even 1% against your predicted outcome, you can lose 10-15% on an option! This can lead to sudden losses which are almost impossible to predict.
- A stock can move in the opposite direction of your analysis based on any news which is completely unpredictable. In option buying, even a small move opposite to your expected direction can lead to massive losses.
Conclusions
Option buying attracts new traders due to their huge return potential & low capital requirement. However, traders need to understand that option buying has a high probability of losses compared to stock trading. Making a high return using option buying over a long term is extremely difficult. Unfortunately, it is the most common trading amongst new traders & also one of the easiest ways to lose money in the stock market. To learn more about a profitable trading system which professionals use, visit this article! The final decision of trading and investment, however, depends entirely upon the reader.
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DISCLAIMER : I am not a financial advisor. I am not for or against any company which I have mentioned in this article. All the information provided here is for education purposes. Please consult a financial advisor before investing.
Contact me at investmentabshuru@gmail.com
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