Possible ways of losing money in stock markets – 6

My recent experience:

In the last article, I have mentioned how investors and traders use futures contracts for trading. While large and institutional investors have the edge trading futures contracts, ordinary retail traders cannot make the optimum use of futures. Recently, SEBI has introduced new rules that have made trading even more difficult in the F&O contracts. Usually, using a combined strategy of futures and options contracts like buying ITM call/put options and selling futures contracts provided significant margin benefits.

But changed rules by SEBI have made life even more difficult for retail traders in the F&O segment. A few days ago, I sold Nifty November Futures at 11550 and bought October 10800 CE for 770. It showed the estimated premium to be around  ₹17500. When I took the described positions, along with  ₹17500, an additional premium paid for buying CE, ₹57750, also got debited. Usually, before the new rules, the only estimated premium was debited from the account.

If this wasn’t the only case, after two days, even the exposure margin started to get locked from the trading account. So, a total of  ₹92750 got locked from the account. I had no choice but to exit the positions for some losses.

Last month, I tried the same strategy with Bank Nifty, and it worked well. I got the full margin benefit. It was in a different account registered with another broker. I will research further, find in-depth information, and post it on the website in the next two to three weeks.

Overview:

Anyhow, we shall continue our article on “Trading Options and Futures without prior knowledge” in our series of “Possible ways of losing money in Stock Markets”. We have already discussed the first five methods, where new retail investors and traders lose money in my previous articles. You can find the links at the end of this article.

1. Following Fake gurus on social media
2. Trading Penny Stocks
3. Falling prey to Value Traps
4. Purchasing high premium stocks
5. Intraday trading with Margin money
6. Trading Options and Futures without prior knowledge
7. Investing in stocks that you don’t understand
8. Taking short term positions against the market move

Trading Options and Futures without prior knowledge:

Trading Options:

Let me start with how new traders get into trading options. Firstly, options contracts are much cheaper than futures contracts. You can buy OTM call/put options for less than 20 rupees (20×75). Although far away OTM options are available less than 1 rupee, and it’s mostly unnecessary to purchase. Such contracts expire worthlessly.

Most of the traders buy far away OTM options since those are available at a lower price. For example, as on 9th October 2020, Nifty closed at 11914.2. So far away OTM call options would be 12500CE and above. Whereas, far away OTM put options would be 10500PE and below. Currently, for October expiry, 12500CE is trading at  ₹28.75 and, 10500PE is at  ₹12.40.

I have had discussions with some traders who do not even know what an options contract is. They did not understand why the option price keeps on losing its value even though the Nifty or stock is not moving that much. Some intelligent people average down the options, which means buying more contracts when the option prices fall. There is a saying in the trading community; the best way to get bankrupt in stock markets is by averaging down the options contracts.

I had spoken to one such person who just kept on averaging 10300PE in July. With just ten days to expiry, he averaged more than 15 contracts at the price  ₹70, which totaled  ₹78750. By then, Nifty was above 11000 levels. I think he sold all the contracts for  ₹10, a loss of  ₹67500. It’s a painful way to lose hard-earned money.

Types Of Options Contracts:

Call Options give buyers the right but not the obligation to buy the underlying assets at a stated price and date.

Put Options give the right but not an obligation for buyers to sell the underlying assets at a stated price and date.

Option Greeks:

An options contract price depends on five factors delta, theta, gamma, vega, & rho. Delta depicts the relation of the option price to change in its underlying security like index, share, or commodity. Gamma is a first derivative of Delta. Theta shows the relation between the option price and time to expiry. Vega implies the volatility of assets’ price movement to option. Rho is the relation between change in interest rates of Govt. securities and option price. This is just a brief explanation. You can find more information on this page.

Options are very different from futures contracts. Future contracts are directly related to the price of the underlying asset. Whereas, Options contracts are dependent on various factors discussed above. There are two ways of making money from futures and options. Options buyers make use of low prices of options compared to the assets. Options Sellers use Theta and Vega to their advantage for selling. It’s an entirely different and in-depth topic; we shall discuss later.

Classification of Option Contracts:

In the Money or ITM Options: Options with a strike price below the current spot price of the underlying assets. ITM constitutes a higher intrinsic value. Intrinsic value means the real value that you receive if the option expires at spot price. Usually, Deep in the Money (DITM) Options have 100% intrinsic value. For example, Nifty closed at 11914.2 on 9th October 2020. 11800CE is the ITM option with a price of ₹183.85, which implies an intrinsic value of ₹114.2 or 62.12%. 11000CE is the DITM option closed at ₹922.8 with an intrinsic value of ₹914.2 or 99%. The options with even lower strike price have 100% intrinsic value.

At the Money or ATM Options: Options with a strike price at the current spot price of the underlying assets. 11900CE is the ATM Call option, whereas, 11950PE is the ATM Put option. Except for delta, the other three important Greeks like Theta, Gamma, and Vega are high for ATM options compared to ITM and OTM options. For ATM options, the intrinsic value would be zero or negative. 11900CE closed at ₹135 with an intrinsic value of ₹14.2 or 10.5%.

Out of the Money or OTM Options: Options with strike price far away from the current spot price of the underlying assets. 12000CE is the OTM Call Option and 11800PE is the OTM Put Option. Mostly, OTM options expire at lower prices or worthless unless there is a favorable sharp move in the underlying asset price. OTM options have negative intrinsic value. For instance, 12000CE closed at ₹82 with an intrinsic value of -₹167.8 or -204.5%. Similarly, 11800PE closed at ₹59 with the intrinsic value of -₹173.2 or -293.5%. Usually, Option sellers benefit by selling the far away OTM call and put options since these expire worthlessly.

Conclusion:

Speculating in Futures and Options contracts is extremely risky for retail traders. While dealing with Futures contracts includes the high capital requirement, buying ATM and OTM options requires limited capital. Retail and small investors should stay away from selling options. Because selling 12000CE for ₹82 would give at the maximum ₹82, ₹6150 for one lot if the Nifty ends at 12000 or below the expiry date. But if Nifty ends at 12200, the loss will be 200 – 82= 118, ₹8850 loss per single lot. Also, the required margin for selling one lot of Nifty ATM call or put options is high, around ₹140000.

If at all, a retail investor should stick to Nifty and Bank Nifty. Since individual shares move violently, there is a major risk of losing capital for inexperienced and retail traders with low capital. Trading options is not aiming for a lottery win or get rich quick scheme. It requires years of hard work, patience, and knowledge. I have been working on Options trading for more than two years. Yet, I make mistakes regularly. Unless and until you are ready to lose money, dedicate time and effort, trading does not make you money.

PREVIOUS ARTICLES:

1. POSSIBLE WAYS OF LOSING MONEY IN STOCK MARKETS – 1
2. POSSIBLE WAYS OF LOSING MONEY IN STOCK MARKETS – 2
3. POSSIBLE WAYS OF LOSING MONEY IN STOCK MARKETS – 3
4. POSSIBLE WAYS OF LOSING MONEY IN STOCK MARKETS – 4
5. POSSIBLE WAYS OF LOSING MONEY IN STOCK MARKETS – 5

Disclaimer:

I provide the information and my views on the website only to educate new investors, stock market enthusiasts, and the common public on equity or stock market investments. Please consult your financial adviser before making any investments in the stock market. In case of any queries, you can contact me via email ID: shivakumar.lachapeta@valueinvesting.online