With the increasing exposure of the stock markets, more and more people are trying a hand in options trading. Options trading have become a lucrative place for individuals to earn money. The reality is certainly different. More than 95% of individuals lose money in Options trading, There are various reasons behind this. Find out the reasons for losses and the steps by which you can be a profitable options trader here.
What is Options trading?
An option is a derivative tool that gives traders and investors the right to exchange the underlying asset on a particular date at a pre-determined price. Options contracts have a legal obligation on the buyer/seller to exchange the underlying on the date of expiry.
The price of Options moves as per the underlying. An options trader capitalizes on this movement to earn a profit. For example, the buyer of a Call option of a Stock will benefit if the price of the stock increases. With this, you can sell the Call option at a higher price and realize the profit.
Options trading involve two parties:
- Option Buyer
- Option Seller
1) Option Buyer
The buyer of an Options contract is called the Option buyer. To purchase an option, the buyers have to pay just the premium money of the Option. The maximum loss that an option buyer can incur is limited to the amount of premium paid. On the other hand, the maximum profit anticipation is Unlimited. This makes option buying lucrative but various other factors work against the option buyer. Some of them are Theta decay, Which represents the decrease in the option prices with time. Due to all these factors, the gain probability of Options Buyers is a mere 33%.
2) Option Selling:
Option Selling, on the other hand, is an expensive business. Option selling required large margin money, to begin with. The maximum profit that an option seller can earn is limited to the premium of the Option. On the other hand, the maximum amount of loss for an Options seller is unlimited. The profit probability of an Option Seller is more than twice that of the buyer of an option at 66%.
This was a brief introduction of Options buying and selling and the Pros and Cons of both. Now let’s see why Option traders lose money.
Why Option Traders lose money:
It is undoubtedly that a stock market is a place where only 1-2 % of people make money in trading. The rest 98% lose money. Let’s see why.
1. Buying Far Out of The Money Options
Option selling requires significant capital therefore small traders are drawn towards Options Buying. They buy Very far Out of The Money Options hoping to hit a lottery. 95% of the time these options expire at 0 and the buyer loses all his money due to the Theta Decay in Options.
2. Risk Management
Risk management is a crucial aspect that options traders forget quite usually. Regardless if you are an Options Buyer or Seller. You need to have a defined risk per trade. This can be ensured by placing a Stop Loss (SL) after you have made a position. Without proper risk management, you can lose all the gains generated through the month or week in one single trade.
3. Not having a trading Style and Setup
Traders try to be master or all but end up being ‘jack of all and master of none. This is not the right approach. You should have a taste of all the techniques and strategies and pick out one strategy that suits you the best.
These were just some of the problems due to which option traders lose money. There are numerous other points such as ‘Being Impatient’, ‘Not having Discipline, ‘Overtrading’, etc.
Not that you know some of the points that lead to losses, let’s find out how you can be profitable.
Steps to become a Profitable Options trader
These are some steps that will help you to evade certain mistakes of majority traders and help you become profitable.
1. Excel at Risk Management
Risk management is the key to profitability when it comes to trading. When you learn to minimize your losses, you will automatically maximize your profits. Start this with keeping an exact percentage of risk per trade. An ideal risk per trade should not exceed more than 5% of your entire capital. Also, more than 25% of your capital should not be used on a single trade. This rule might not work on an extremely small account but should be followed.
2. Avoid Buying OTM Options
Buying options is in itself dangerous as the premiums of options erode as time passes. This is known as Time Decay or Theta Decay. The farther you buy the option the lesser it will move in your favor. This happens even the underlying asset moves according to you. If possible use hedge multi-leg option selling strategies to increase your probability of profitability in options trading.
3. Follow your Stoplosses Strictly
This is one of the most important rules that you should follow. Options traders tend to stick to a losing trade hoping for a miracle turnaround. This does not work. You have to keep a well-defined stop-loss of a maximum of 2-4%. This should be followed no matter what. You can re-enter at a better price but never let your losses run. On the other hand, let your winning trades run. Don’t exit a position that is in profit. Keep a Trailing Stop Loss and let it running till you achieve your following target.
4. Lack of Knowledge
Options trading is a place (business) where the entry barriers are low. Any person with an active Demat account can start trading in options. Due to this people forget to learn about the basics of options before they start to trade. You cannot succeed in Options until you know enough about all the important factors that affect the price of options. Options trading is not a get-rich-quick place where you can come with 100 rupees and leave with lacks. Due to this attitude, many lose money in options trading. Hence to start trading in options, obtain a strong understanding of options, how they work, and various other parameters.
5. It’s a Bad idea to Average Down
Averaging is a method that is used to buy stocks. In this method, you buy more irrespective of the price going up or down. Some imply the same in options trading. In a losing trade, people tend to buy more. This causes the losses to expand exponentially. The right way to average is to buy more when your view is right. Averaging should not be followed in any losing position thinking it will turn around.
6. Maintain Trading Log
Successful traders maintain a strict log where they record every trade that they take. The reason behind the trade, the entry and exit points, etc, everything is mentioned there. This is done to evaluate your performance. Once you make a loss, analyze the trade to find out what went wrong. Once you figure out the reason behind the loss try to learn from it and not repeat it. In this way keeping a trading journal will help you learn from your losing trades and help you become a profitable trader.
These were some of the main points that you as an Options Trader should follow to achieve profitability.
Conclusion
To sum it up, Options trading should be treated as a business. Know the ins and outs of options before putting any real money behind them. Make sure to avoid the mistakes listed here and follow the steps such as Risk management, Avoid buying OTM Options, etc. With these, you will stay ahead of the majority of the traders.