Options, by far, one of the most useful instruments in the financial derivative markets, are also a highly misunderstood product. The flexibility of options market allows us to leverage our position to boost returns, hedge our risk, and make a profit from a trending (both upside and downside) and in a sideways market.
Although, the main purpose of the introduction of options is to provide a hedge to a portfolio, or any existing exposure, it is often used by short term traders who make it more speculative in nature.
Options trading, when used for speculation, carry a substantial risk of loss. A successful option trading, unlike cash and futures segment, requires a very high skill set. This article will help you understand some of the many qualities of a successful option trader.
Understand the Risk
Although the usual thought process is to let the options expire worthless in the case of selling, it is extremely important for us to understand how much risk we are exposed to at any point in time.
Selling of options, theoretically, carries a potential unlimited risk if the underlying moves contrary to our initial outlook. Many may argue that it is better to buy an option. They are less risky in nature, as the potential maximum loss is to the extent of the premium paid. It is still not recommended to let the options premium become zero in case of long options.
Experience suggests that if we are long options and the option premium has dropped by 50% from the initial purchase price, we should reevaluate our view on the option strategy/underlying, and most importantly consider an exit to save the remaining premium from getting eroded. Options are best traded when there is a low risk: high reward scenario.
Understand the Greeks
Most of the market participants wrongly assume that the “Greeks” are part of an options price. Option Greeks are used only to estimate what an option price might do reacting to specific market changes.
Various parameters associated with an option strategy like the implied volatility, moneyless associated with the option, Break-even of the trade, Greeks like Delta, Gamma, Vega, and Theta should be carefully understood both theoretically and practically before initiating any options trade.
Understanding the Trading Style and Personality
Each trader has a different personality. One should adopt a trading style that suits his or her traits. Some of us may be comfortable with day trading, where we buy and sell options several times during the day to make small profits, whilst others may be comfortable with positional trading, where we form trading strategies to take advantage of unique opportunities, such as time decay and volatility.
A successful option trader is disciplined in all aspects. It is necessary, and requires patience, to wait for a good opportunity to trade. Waiting for the right opportunities may mean that we do not trade out of compulsion.
Sticking to the risk management plan along with a pre-defined exit strategy requires a lot of discipline as we can easily get swayed away by the herd mentality and or emotions especially whilst initiating trades before a major event. It is recommended to stay hedged within our option trades to protect any major damage to the capital.
Trade and Money Management
While trading options, it is necessary to plan our trade, than to trade on instinct and impulse as the latter takes away from us the likely edge to succeed. If we do not have a plan, we may end up placing random and directionless bets, and consequently, lose a major chunk of the investment forcing us to retreat from trading further.
An options trader must have a sound money management technique. We need to use our capital wisely. The strategy we choose should be carefully implemented, understanding the live market implication of the same. Risk management and money management must take priority and cannot be ignored.
It is quite natural for us to look at options as either a “Get Rich Quick” or a thrill-seeking instrument. But anyone who realizes that options are risk containing financial instruments and/or products which can provide us with consistent gains over a long period in time if strategically driven. Try to follow above 5 qualities of a successful option trader and you would soon witness a dramatic improvement in your profitability.
Tanu Shree Jain is Knowledge Coordinator at Elearnmarkets.com and StockEdge. She is a commerce graduate from Delhi University. She is Currently pursuing CA. Also Studied CRTA from Kredent Academy.