Options — Whether to buy or sell??
Tags: Options Trading, Risk Management, Investing And Trading, Finance

“Risk is our business, that’s what this starship is all about. That’s why we are aboard her - Captain Kirk”

Before beginning to trade in options one should be completely aware that they are risky instruments. Be it buying or selling both of them have their own sets of risk. Such is the riskiness that if not taken care off it will lead to devastating losses. But then what I think is risk is not something that we can avoid. Better embrace it, manage it, and then use it to make big bucks!!

Option pricing is a pretty complex subject. Not the pricing per se. To some extent it is simple. It depends on the intrinsic and extrinsic value. Price change is where the complexity lies. This is where the five factors fondly called as Greeks take control. Price not only depends on the individual Greeks but also on the interaction among them and that is where the complexity begins.

Options price depends on 3 major factors

1. The direction of movement in the underlying (Delta and Gamma)

2. How fast the movement is (Vega)

3. Time to expiry (Theta)

These above-mentioned factors make buying options a tough task to do in my opinion. You need to be right on all three counts to make money here. Not only you need to be right on the direction but also on how much directional movement will be there and how fast it would be. And every single day when your view is wrong on even one front it will cost you in the form of theta decay. Yes, the risk is definitely less here. First, the downside is limited to the tune of premium paid. Second, buying means you go long on gamma which means when you win you win big but when you lose you lose small. But then to make money here I need to be an expert in predicting the markets which I am definitely not.

The above reason is why I was fascinated by option selling. The only thing that I needed to make sure in a crude sense is that even if I am wrong I should not be wrong enough (factor 1 and 2 mentioned above) and I still get to keep my profits. Because irrespective of what happens time value of money will always work in my favour. An efficient business strategy in my view which gives me enough bandwidth to concentrate on the most important factors in trading - Risk and Capital management. This is easier said than done. Because you don’t know how you will react when money is on the line!!

Options selling is not as rosy as it sounds. My derivatives professor once told me that it’s like picking pennies in front of the road roller. This statement was enough to make me aware of the risk involved. When you are writing options you are short gamma which basically means when you win you win small and when you lose you lose big. It sure sounds funny, right!! Well, then why any sane person will write options ever. It is because ~90% of options expire worthless. That means you will have positive expectancy on the trades. Let’s say that if you have a risk-reward ratio of 2 that is you are risking 2 to get 1 (Crazy RRR but conservative as this is options we are talking about!!) and a 70% probability of winning you will still end up making some money at a gross level. But those 30% of the losing trades can kill you if not taken care of. And this is where risk management comes into play.

Both buying and selling have their own disadvantages. In buying you need to be right on all counts and in selling a single trade is enough to kill the capital. Then what should one do? Well, I think instead of choosing sides it is better to be an opportunist and this is what I do. Eventually, one needs to make money. It doesn't matter whether it comes from only buying or only selling. One strategy that justifies this statement is deploying spreads while trading. Spreads hedge the downside losses as you end up buying a further OTM strike. Spread also lessens the effect of short gamma which basically gives more time to let the trade play itself out. Well, you will end up sacrificing returns due to the cost of reinsurance. But as everyone in the field of investing and trading likes to say, you will get a good night’s sleep which is totally worth it!!