Buying options — The myth of limited losses

Everyone who knows anything about options will tell you this.

“Option buying is better than options selling. At least the losses are limited”

For years, people have been buying options taking comfort in this myth of limited losses, which is utter nonsense.

I am going to say this:

If you buy options, it is easy to lose all your money. And there isn’t much of a loss between losing all your money and “unlimited losses”.

If you sell options, it is unlikely that you will lose all your money. Read that again.

How can that even be?

Let’s go ahead with this example:

You have 60,000 Rupees in your account. NIFTY is at 10300. Let us say NIFTY 10300 Call and Put option is trading at 100 Rupees. The premium on one lot (75 options) of either of these options is 7,500 Rupees.

You think the market is going up. For sure, it is not going down. You have two choices, buy a 10300 Call or sell a 10300 Put.

Buying:

You can buy up to 8 lots of 10300 Call option. Let us say you bought 2 options. To break even on this you need the index to go above 10400. If NIFTY expired below 10400, this option expires worthless and you lose 7500 X 2 = 15,000 Rupees.

Some investors bet way more than 2 lots if they have 60k in their account. They will lose all the money if they buy 8 NIFTY 10300 put options and NIFTY expires above 10200.

Selling:

To sell a 10300 Put, you need a margin of 60,000. So you can sell only one lot. You will break even if Index expires above 10200 and lose money only below that. Here is your table of P&L at different levels of NIFTY.

What do we know from this?

1. Making money on the put is easy and is more likely given your bullish view. You just need to avoid being wrong by more than 1%
2. Making money on the call is harder because you need a 1%+ move in your direction. You need a 2% move for the call to be a better choice than the put
3. Yes, there is a possibility of making a lot of money at higher levels, but we are talking about 3% plus move, which is kind of unlikely
4. You can buy calls for all your money, and lose it all by being wrong by just 1%.
5. To lose all your money on selling a put, you need a correction of nearly 10% on NIFTY. And trust me, on that occasion you have much bigger problems to worry about than a 60,000 Rupees loss 🙂
6. Unlimited loss on selling options is a myth, when it comes to NIFTY and BANK NIFTY index options. It does not happen often, or even rarely. It is just a bogeyman created by people who want retailers to buy options. On NIFTY, to lose 60,000, you need a 10% correction, to lose 1.2 lakhs, you need a 20% fall. What are the odds? Of course, we are not talking single stocks here. Especially stuff like SBI on 25th October, 2017
7. The margin requirement on the sell put acts as a limit which prevents you from taking big bets. And betting small consistently is more often than not a better strategy.

Tailpiece: All of this is more likely when you are doing index options. If you are doing stock options, in which the underlying stocks can move 10% or so a month (PSU banks courtesy Nirav Modi) or say even 30% territory (PNB, again courtesy you know who) all of this math goes for a vacation. Buying and selling single stock options requires brass balls. And you should be very scared of that stuff unless you know what you are doing. Because just like the myth which we started with, there is another myth which goes, “darr ke aage jeet hain”. No, there is no jeet after darr. There could be a large MTM loss though.

TL;DR: Buying options is a sure way to lose money in the long run.

How about you? Are you a seller or a buyer? Tell us more about your trading style in the comments