Option Trading Pitfall: The Lottery Ticket Trade

When just starting out in options trading, especially if you haven’t had much training, it’s easy to make mistakes. The following article discusses one such mistake rookies often make and gives you ideas on how to avoid making it yourself.

I have been teaching trading in India for well over a year now at the Online Trading Academy in Mumbai. I trade in nearly every asset class and also encourage my students to do the same in order to take advantage of many market opportunities. When I ask my students in class, “How many of you trade options?” I usually get several hands raised. However, when I ask how many of them are profitable in trading them, most hands go down.

In courses I teach for relationship managers and brokers, I also ask how many of their clients are trading options successfully. To my amazement, I have not found too many profitable options traders in India. This made me look further into the strategies being employed by those traders to see if there is something they are doing wrong and if I could offer a solution.

One such mistake that novice traders make in the Indian option markets is that they try to trade deep out of the money options in order to buy cheap premium. This strategy is often referred to as a lottery ticket as the payouts can be great, but the odds of winning are extremely slim. When trading, we want consistent wins in any market we trade. Most successful traders became that way from winning on a regular basis and not gambling with poor odds to try and make a big win.

Let’s examine that “lottery ticket” trade and compare it to one that has a higher probability of making money. As of 19 October 2011, the Nifty had retreated from a supply zone near 5150. A trader who wanted to take advantage of the potential bearish drop could buy puts. They would profit from a drop in price as well as an increase in volatility by doing this. On that date, the open interest looked like this:

5200 puts = 11,86,750

5100 puts = 41,88,900

4800 puts = 83,04,000

Looking at the high open interest; it appears that many traders are buying their lottery tickets at a strike price of 4800 on the Nifty. But is this the smartest thing to do? Most traders buy this option because of the low premium cost. Looking at the different options, the cost to buy the 4800 put was only Rs. 217.50 (there are 50 shares per contract).

Figure 1

This is a lot cheaper than the 5100 puts (Rs. 2645) or the 5200 puts (Rs. 5437.50). But is it the best trade? Most option traders ignore the Greeks in trading. The Greeks are measurements of risk in options trading. They can also be used to gauge potential profitability in the trade. Assuming the Nifty is currently trading at 5116, if the Nifty were to move to 5000 at the expiration of October 25, the trader who bought the 4800 put would profit about Rs. 298 (Rs. 257 per point move in the Nifty). Not bad for an initial investment of only Rs. 217. But wait, holding to expiration would also cost you time value. You would lose about Rs. 86 per day in time value and that would erase all of your profits in the trade!

Buying the 5100 put costs more, but the larger Delta compensates for the loss in time value. The same movement in the Nifty profits Rs. 2744, (Rs. 23.66 per point move in the Nifty), a nice gain for a Rs. 2645 investment. Even after time has eroded, there is still a profit of about Rs. 1300.

The last trader who bought the 5200 put had to pay the most, but gets to participate more in the movement of the Nifty. They receive Rs. 38.62 for every point the Nifty falls. This translates into a gain of about Rs. 4480. Even when time erodes, they are left with a Rs. 2574 gain! The 5200 put initially has intrinsic value of 84 points, or Rs. 4200 per contract. You will get that back when you sell or at expiration. I think of it as a deposit to make more money in the movement of the Nifty. Removing that intrinsic value, you are only paying Rs. 1237 in time value to make Rs. 2574. That 208% gain is a lot better than gambling on a cheap option only to make nothing!

See Trading Academy for the rest of the story

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