7 Sins of Options Trading — Part 3


6. Trading Illiquid Options

Some Options are Illiquid. That is, the bid and offer don’t exist, or they are wide apart. Examples are

  1. Deep In the Money Options
  2. Next month, or next to next month Options
  3. Options of smaller stocks.

How does this affect you? Let us take one example:

The bid-offer on Castrol December 410 Call is 8.00–8.30. The stock is at 407. So it is an at the money call. Assuming you hit the offer to buy and hit the bid to exit, you are paying a bid-offer spread of 30 paise. While this may not seem a lot, this is 3.75% of the option’s price. That is quite a bit. If you have to execute larger quantities this becomes worse — more than 5%! In Rupee terms, at a lot size of 1400, this is 420 Rs, a significant number.

Castrol Jan 410 Call was not traded today, which means you cannot enter or exit a position.

Compare it with NIFTY, where 10300 At the Money Call is trading at 132.00–132.75. That’s just 75 paise, which is less than a percent. Bigger quantities won’t hurt much because of liquidity.

Takeaway:

Trading in illiquid options will cause you losses because of the bid-offer spread

Solution:

Stick to liquid options: NIFTY, Bank NIFTY, and big stocks like SBI.

7. Selling Naked Options

One day before the government announced the stimulus package for banks, SBI 270 Call was trading around 1 Rupee. The next day it was trading at more than 50 Rupees. If you had sold this call without protection, it would have lost you more than 1.5 Lakhs per call!

Takeaway:

In stock markets, the impossible happens roughly twice a year

Avoid selling options naked without protection. You could go massively wrong, and the cost of that could be humongous.

Solution:

When you sell a call, buy a higher strike call for protection. Example, when you sell SBI 270 Call, buy an SBI 275 Call or a 280 Call.

When you sell a put, buy a lower strike put for protection. Example, when you sell SBI 270 Put, buy an SBI 265 Put or a 260 Put.

Bonus Sin: Time Decay

Option Prices decrease with time.

They decrease rapidly towards expiry.

They also decrease on Fridays because of what is called the “weekend effect”. This is when traders sell options to earn three days time decay on Friday, assuming nothing happens on the weekend when markets are shut.

Takeaway:

If you buy options near the expiry or on Fridays, there is a high chance that you will lose money if the stock does not move in your favour.

Solution:

Simple. Avoid buying options in these times!

Are you a sinner or a saint? Let us know in the comments!

This post is part of an initiative by Sensibull — India’s First Options Trading Platform to make retail investors more profitable in Options Trading. If you would like to get more on this, visit our free page Sensibull Manifesto which gives the right practices and advice on trading psychology, trading dos and donts, bet sizing, risk management, etc

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