When people think of investment, they think of buying stocks on the stock market. Many of them are probably unaware of terms like options trading.
Buying stocks and holding on to them with a view to make long term gains is one of the most common investment strategies. It's also a perfectly sensible way to invest, providing you have some idea about which stocks you should be buying or using a broker that can offer you advice and guidance on such matters.
This approach is known as a buy and hold strategy and can help you increase your wealth in the long run, but it doesn’t provide much, if anything, in the way of short term gains. These days, many investors are choosing to use a more active investment style in order to try and make more immediate returns.
Thanks to the range of online brokers that enable investors to make transactions on the stock exchanges with just a few clicks of their mouse, it's relatively straightforward for investors to be more active if they wish to. There are many people that trade online on either a part time or a full time basis; buying and selling regularly to try and take advantage of shorter term price fluctuations and often holding on to their purchases for just a few weeks or days, or even just a couple of hours.
There are plenty of financial instruments that can be actively traded. Options, in particular have proved to be very popular among traders and options trading is becoming more and more common.
In very simple terms, options trading involves buying and selling options contracts on the public exchanges and, broadly speaking, it's very similar to stock trading. Whereas stock traders aim to make profits through buying stocks and selling them at a higher price, options traders can make profits through buying options contracts and selling them at a higher price. Also, in the same way that stock traders can take a short position on stock that they believe will go down in value, options traders can do the same with options contracts.
In practice however, this form of trading is far more versatile than stock trading. For one thing, the fact that options contracts can be based on wide variety of underlying securities means that there is plenty of scope when it comes to deciding how and where to invest. Traders can use options to speculate on the price movement of individual stocks, indices, foreign currencies, and commodities among other things and this obviously presents far more opportunities for potential profits.
The real versatility, though, is in the various options types that can be traded and the range of different orders that can be placed.
Option sellers tend to be efficiency oriented. Always attuned to maximising odds, sellers key toward being efficient, and efficiency often can mean getting the most bang for your buck.
Investing with options— an advanced trader will tell you— is all about customisation. Rewards can be high — but so can the risk— and your choices are plenty. But getting started isn’t easy, and there is potential for costly mistakes.
Option traders frequently start their trading career as options buyers. That can be a great strategy when executed properly, but time value works against you. When you are an option buyer, you have to be right about market direction and about the amount of time it will take the market to move.
But did you know that it is possible to be on the other side of the trade?
An options writer sells, or “writes,” the option contract that option buyers are paying for.
By creating the option, the option seller is taking on the opposite responsibilities of the option buyer. If the option buyer wants to “exercise” their option, you as the seller will need to deliver on the contract. That gives the writer an obligation to deliver. Selling options is done opening a short position and short selling them. This is also known as writing options, because the process actually involves you writing new contracts to be sold in the market. When you do this you are taking on the obligation in the contract i.e. if the holder chooses to exercise their option then you would have to sell them the underlying security at the strike price (if a call option) or buy the underlying security from them at the strike price (if a put option).
Writing options is done by using the sell to open order, and you would receive a payment at the time of placing such an order. This is generally riskier than trading through buying and then selling, but there are profits to be made if you know what you are doing. You would usually place such an order if you believed the relevant underlying security would not move in such a way that the holder would be able to exercise their option for a profit.
For example, if you believed that a particular stock was going to either remain static or fall in value, then you could choose to write and sell call options based on that stock. You would be liable to potential losses if the stock did go up in value, but if it failed to do so by the time the options expired you would keep the payment you received for writing them.
There are distinct benefits of selling options:
1. You get paid your potential profits up front in the form of the option’s price or premium.
2. If the option expires out of the money, which most options do, then no one will want to exercise the contract and you will keep your entire premium.
3. As time value melts, the decline in the option’s value reduces your liability and risk as the options seller - because you already sold the option for a high price and took the premium, you can later buy it back for a cheaper price as time value melts, allowing you to exit the trade any time you like.
4. You can close your trade at any time - all you need to do is to remove the obligation by buying the option back and washing out the trade. This can be done on the open market at any time.
5. Rolling down or Rolling up is possible - if the option seller sees unfavourable moves, he can still make money by shifting the option strike by rolling down(in case of puts) & rolling up(in case of call). This is smart way of making money even in adverse situations. Smart traders also go much lower or higher on strike price by selling far month contracts & take the benefit of Theta(time value of option) to protect themselves.
Most people keep asking me, why I keep referring option selling similar to investing. In reality, if option selling is done with adequate capital it is exactly similar to investing, it requires:
a) Right selection - like picking right stock is important, picking right option to sell is equally important
b) Right Timing - picking a good stock is not enough, but picking it at right time is important. Similarly, selling an option is not enough, selling at right time is important.
c) Patience - value investing is all about having patience, so does option selling. You can't become rich overnight. It is consistent effort of finding right options to sell to become rich over time. One has to be consistent while selling & continuous evaluation is important like we monitor stocks.
Let's understand simple maths of how option selling can be similar to identifying a multi-bagger :
We aim to earn 3% every month & we are doing it quite consistently as you see in our trade sheets month on month(sheets can be checked on links given at the end of the article). Now let's suppose we have Rs. 100 with us today & we continue with what we do. Remember, for most people it might be a boring exercise, but see what it becomes if done for 25 years :
100*(1.03)^(25*12) = Rs. 7,09,851/-
It is like buying a Rs. 100 stock which will be valued at Rs. 7,09,851 after 25 years. The idea is too keep it simple and let it grow. As we are doing it on 10 lacs, the idea is to make it 709.85 Cr.
Even if I don't compound it, still the number would be 100*(1.36)^25 = Rs. 218008/-. On 10 lacs, it is 218 Cr, not bad. Isn't it!!!
Most people ask me a very common and simple question. They always ask, "how do you know which strike we should sell in order to protect ourselves against adverse moves." Well, it is pretty simple. All you need to know is a bit of Technical Analysis & Z Test-Score to arrive at this. Most option articles you must have read in past must have provided you with what options are & their terminology but what no one tells you, which strike option you should sell.
Let's take an example of Andhra Bank, recently we at Profit Idea took the trade & made good money on the counter. Here is the chart which I posted to all my readers :
On technical front I was expecting a pull back rally on the stock, which did happen. Now at times, your technical charts can go wrong too. So ideally, smart option sellers would combine something that we use heavily at Profit Idea while trading i.e., TECHNO-DERIVATIVE Trading.
In order to ensure that we don't loose money, I applied Z Test on the stock price of Rs. 35.95 when the hammer was getting formed at the bottom & let's check the result of Z-Test :
To apply Z - Test one would need few things and it can be derived by a simple formula :
We need to find out Mean, SD, Range, Upper End and Lower End.
So the formula for the Mean = Ln(Spot) + (Rate of Interest - Std Dev^2/2)*time
SD = Std Deviation*√time
Range = Mean +- SD*Z value
Upper End = e^upper range
Lower End = e^lower range
Let's apply the test : Spot Rate for Andhra Bank(12th March 2018) Rs. 35.95, Standard Deviation = 67.22%, Rate of Interest(Bank Rate taken from RBI website) = 6.25%, Time = 1 month(Usually taking current month is always better, one can take exact number of days too).
Apart from this information, we need to define our Level of Confidence for taking the trade. We at Profit Idea prefer to take 90% Level of confidence to ensure maximum safety of funds. This ensures, only 5% risk, as we are selling put, so in two-tail test our probability of success is 95%. Hence, Z value for 95% is 1.645 if we check Z table.
Mean = Ln(35.95)+(.0625 - .6722^2/2)*.0833 = 3.5685
SD = .6722*√.0833 = .1940
Upper Range = 3.5685 + 1.645*.1940 = 3.88763
Lower Range = 3.5685 - 1.645*.1940 = 3.24937
Hence, we arrive at Upper End = e^3.88763 = 48.80 & Lower End = e^3.24937 = 25.77
Now, as a TECHO-DERIVATIVE Trader, we know that we should Sell any strike price put below Rs. 25.77 as we were expecting a pull back. So we decided to Sell Andhra Bank 25 PE & we made good money.
This is what I ended up making in no time in my personal account. Simple and easy way of making money.
TECHNO-DERIVATIVE Trading is possible to do on intraday basis as well. We have been trading Bank Nifty weekly options & other stock options on regular basis and see some of the intraday consistent Profit screenshots below :
7th Dec, 2017 Bank Nifty Weekly option expiry(MTM Profit Rs. 26776) :
14th Dec, 2017 Bank Nifty Weekly option expiry(MTM Profit Rs. 64,698) :
Overall Profit for Dec, 2017 :
4th Jan, 2018 Bank Nifty Weekly option expiry(MTM Profit Rs. 2.11 lacs) :
18th Jan, 2018 Bank Nifty Weekly option expiry(MTM Profit Rs. 8.07 lacs) :
25th Jan, 2018 Bank Nifty Weekly option expiry(MTM Profit Rs. 5.55 lacs) :
Overall Profit for Jan, 2018 :
1st Feb, 2018 Bank Nifty Weekly option expiry(MTM Profit Rs. 9.46 lacs) :
8th Feb, 2018 Bank Nifty Weekly option expiry(MTM Profit Rs. 5.51 lacs) :
15th Feb, 2018 Bank Nifty Weekly option expiry(MTM Profit Rs. 5.14 lacs) :
Overall Profit for Feb, 2018 :
8th March, 2018 Bank Nifty Weekly option expiry(MTM Profit Rs. 5.45 lacs) : Kindly note 1st March was Holi Holiday. So no screenshot available for that date.
15th March, 2018 Bank Nifty Weekly option expiry(MTM Profit Rs. 6.26 lacs) :
22nd March, 2018 Bank Nifty Weekly option expiry(MTM Profit Rs. 4.41 lacs) :
28th March, 2018 Bank Nifty Weekly option expiry(MTM Profit Rs. 3.40 lacs) :
Overall Profit trading options using TECHNO-DERIVATIVE Analysis for Dec, 2017-March, 2018 :
Now, we ended up making 67.71 lacs or 6.67 Million in just four months time on a single account, only on capital of Rs. 15 lacs. Kindly note, apart from weekly trading, regular trading is also done on daily basis and that increases the overall profit. Most people might argue that it is impossible, but all screenshots above proves what we do & how TECHNO-DERIVATIVE Analysis helps in making consistent Profit. We have trained numerous students, clients, traders to do the same & we have not 1 or 100 but 100's of accounts where we are making consistent money at Profit Idea.
Most option traders, also argue that making consistent Profit by selling options is impossible, we at Profit Idea have been doing it so consistently.
Varun is the director of Profit Idea. He is a multi-skilled experienced professional in academics, corporate and administration fields. He has over 10 years of corporate training experience in the field of finance & provides training for CFA, MBA, Stock Market (Derivatives, Fundamental & Technical Analysis) & various other financial subjects. He is also associated with various institutes, boards & banks. Varun holds financial and investment qualifications from Delhi University, Yale University, London Business School, Indian School of Business, Columbia University and IESE Business School.