The allure, the mystic odds, mammoth single day swings and darn cheap investment prices attract the most intelligent and not so intelligent to trade options from all corners of our country. On first sight, we see investment amounts as low as a few thousand rupees to control (theoretically) large sums of money, they move 20% – 40% in a single day – “What if I could make money too?” you think to yourself.

Today, we’ll cover 8 things you absolutely need to know before you invest in options. The leverages and swings can make or break a trader, with gains of 100% or the possibility of the option expiring worthless on expiry day.

1. Cheap out of the money options

Out of the money options are priced much lower than at-the-money options. I know a trader who purchased a deep out of the money call option and despite the underlying moving up 1% on that day, his call option actually declined. If you do not know how options are priced, you should keep in mind that trading in the money options or at the money options has more liquidity and better chance at success. Perhaps the best times to trade out of the money options are if you are writing them or you are buying them because of a merger announcement or a big event like the union budget or election results.
Summary: Buy only in the money options/at the money options (for naked traders)

2. Learn Option Writing

When buying a put or a call option; you need to be right on direction as well as timeframe (must happen many days before option expiry) or else you lose money. When writing options you can gain if you are correct in deciding direction, time value is on your side. Theoretically your risk is unlimited and profit pre defined, however if you manage your positions the situation of an extravagant loss does not arise.

3. Manage Risk – Don’t Go Broke

Do not, and I repeat – Do not think of investing a large portion of your capital in a single options trade. If the reward of a naked option is 40%, the risks are also pretty high, sometimes 20%-30% & even 100% if it expires worthless. All traders should manage risk, if in stocks you risk no more than 1% on a single trade then you should risk the same amount in options as well. Price moves are very wild and must be normalised by investing small trade amounts to mitigate the possibility of huge losses. Option prices can go to zero on expiry day.

4. Option Charts

Do not trade the option chart, you must trade the underlying price because that is your first contact information in the market. News, fundamentals, indicators are first reflected in price.
Also, there is nothing written in stone when trading the markets, I know traders who successfully trade option charts – however I think for a newbie it may amount to some serious loss of hair – stick to the basics and you will maintain sanity as well as a healthy ledger balance.

5. Liquidity

When I started out with options, it was a refreshing new world filled with new theoretical price models. When I finally got down to a beautiful trading strategy on a reliance Infrastructure, I found out that the number of contracts traded per day were so low that it produced a large bid/ask spread. That is your first clue to low liquidity option chain contracts. Make sure you trade in a series that has enough liquidity so you can get the best price on entry and exit, markets need liquidity to be efficiently priced.
Summary: You need to trade option contracts that have a tight bid/ask spread or you could lose a huge portion on just entering and exiting, illiquid contracts should NEVER be traded.

6. Expiry

The last 7 days to expiry, the value of options which are out of the money will deteriorate severely. This means if you are holding Reliance OTM Calls and there are say 7 days to expiry, you should consider exiting your position with immediate effect because the time value of your contract will deteriorate very fast. As an example on Monday 26th May 2014, with only 3 days to expiry a nifty call option OTM contract fell 45%.
Summary: Do not hold naked OTM calls/puts with few days left to expiry. They will expire to 0 on expiry day if current prices do not reach strike prices.

7. Vega – The Volatility Expert

The market has a personality, it is a beat by itself. It senses danger, volatility and personifies mass hysteria and panic selling. Efficiency is when many traders analyse the market to put on traders, it destroys any opportunities left to exploit.
You see, when there is a big announcement to take place like election results, earning announcements or a M&A deal, the market will add a premium to the existing contracts to ‘price in’ that volatility. Those ‘extra’ rupees you pay to buy an options contract is called the Vega, which is over and above the intrinsic value.
Now suppose you bought a call option at Rs 30, the market is already expecting a earnings announcement, after the announcement let’s say that the underlying stock did not move because the announcement was at par with expectations – The call option you bought will lose value because the volatility was just shot down. In the real world, price will generally move – and If it does move up your calls will make money and you will never know that you had a vega risk in the trade. This point is just to caution you that big events are priced in option contracts

an example of volatility imploding is with the use of the VIX index which plummeted after the 16th May election results announcements – take a look my trader friend:

5 options volatility implodes

8. Pick A Direction – Get a Method

If you trade naked, or using spreads where you primarily buy options (I am not talking about delta nutral strategies which do not look at direction but other factors) then you need to find a method to trade with. The Newton Method which is on Trade Academy teaches you that, there are also other countless methods you can use to gauge trend direction. Options are instruments that rely on the underlying – it is vital for trend followers to find a way to gauge which way the stocks are most likely to move to put on a trade.

Trade Well

Prateek Singh

Prateek Singh

Prateek has been trading for over a decade using price action methodology. He enjoys electro house music, writing & reading about business entrepreneurship

  • Dilip Sarkar

    Waiting for TradeAcademy eagerly, excellent post!!

    • Prateek Singh

      Thank you Dilip, I’m quite excited about Trade Academy too

  • Vivek Koli

    I ENDORSE YOUR ABOVE VIEW. I WOULD LIKE TO ADD 90% OBSERVATION 10% EXECUTION WITH VALUE AND/OR TIME ENTRY BRINGS GOOD MONEY.

    • Prateek Singh

      Hi Vivek, thank you for adding your input. How long have you been trading?

  • karan sharma

    sir nice article ….
    well u just said that there r various methods to gauge trend direction like NEWTON METHOD …. could u name a of couple more such methods used to trade the trend direction…
    thankyou

    • Prateek Singh

      Thank you Karan, well – the best place to learn the newton method, ambush method or general trend identification will be when TradeAcademy launches. Have patience, it will definitely be worth it.
      What timeframe do you trade usually?

      • karan sharma

        i usually trade on 5 min charts keeping a check of daily charts as well … but havent been able to make profits in this bull run as i began trading 3 months back and my account is still in red…(haha)
        how to make it green??

        • Prateek Singh

          Hey Karan,
          There are two problems when trading with 5min charts.
          1) You make an excessive amount of trades and lose your edge
          2) Unless you consult a higher timeframe you will almost never be able to catch a bull move as seen on the daily charts.

          Another problem with lower timeframes is that you can get whipawed alot.

          I would suggest to get a solid method, trade 30min or above timeframe.

          • karan sharma

            thank u … i will try to change my trading way…also
            while using 30 or 60 min charts should a bracket order be used for trailing stops
            how to determine when a POTENTIAL EXIT signal is generated(as RAGHU KUMAR talked about this in an article in mumbai newspaper recently)…

          • Prateek Singh

            Bracket orders can be used, but you can also use a regular stop loss order after you are in a position.

            Exits are the elusive, especially for the trader. I use a combination of reaction bars and fixed exits. For example if I’m risking Rs 10k my exit would be when I reach 20k in profits

      • chetan mahadik

        Prateek sir, I have followed your Newton method combined with space theory. It is very much helpful & I have developed a great discipline judging trend reversal. I am very much lucky to follow you on trade academy.

        You made me realise that share market is a scientific world rather a gambling stuff. Thank for your valuable guidance.

  • ashish

    i had similar feeling about VIX, but could not muster courage to short it (btw i never traded it, not sure about its liquidity and other aspects)!

    • Prateek Singh

      The Vix is one crazy monster, sometimes I wonder – why would somebody want to trade volatility directly? it’s probably a better idea to trade a naked call/put, or write an option after a major event unfolds. The Vix also has a pretty large contract size, I have never traded it – probably never will!

  • Vivek Koli

    I M IN MKT FOR DECADE. OPTIONS JUST ONE YEAR. U SHD HAVE CLEAR PERCEPTION . FORGT ABT OTHER THINGS. JUST FOCUS ON STRENTH OR WEAKNESS. TRADE IN NIFTY FUTURE AND IN THE MONEY OPTIONS . THATS MY WAY

    • Prateek Singh

      Interesting Vivek, trading in the money is particularly important as mentioned in the article above too. Many option chains are very iliquid, the options market has a lot of growing to do in India

  • Gaurav Yadav

    Prateek, have seen your videos both on trade academy and market Scientist as well; have been on a look out for a strategy that you mention always, trying to make it in green…would need help on charts, website which gives me freedom to study hourly, minutes and help me scribble on the charts; then some method to control the emotional side…i think which forces me to take positions…:(:( searching for that edge

    • Prateek Singh

      Hi Gaurav, I understand that finding a method that works in the backtest as well as live trading is challenging. There are only three things that matter, the method should be simple, have a hit rate of atleast 70%, risk reward of 2 or greater.
      In my experience the complicated methods traded on lowered timeframes created an emotional outburst far too often. A small timeframe will cause missed opportunity, wrong trades and early exists – all of which will cause you to be upset. Trading on a timeframe 60mins or above has been useful for me.

  • amit

    Dear Sir,

    I’d like to congrates Team_RKSV for its wonderfull,motivating initiative TradeAcademy.in.all Videos,production quality is unmatched and innovative,it’s India’s even better reply to tasty trade’s dough.

    I want to thank prateek sir for all teachings in a very effective way,i appreciate your energy during tht entire exhaustive session
    also I want to thanks all mentors for thr indepth explaination about various complex topics.

    My name is amit,a research student,i am learning trading options bit by bit.
    is it working fine?

    Pl. help

    Sincere

    AMIT

    • Prateek Singh

      Thank you for your kind words Amit, We strive to make the best courses in the world. Yes you can email directly to support@tradeacademy.in

      • amit

        Sir, i did it plz check.

        • Prateek Singh

          You should have got an email from Prateek

          • amit

            when did u send it Sir?

          • Prateek Singh

            Sent it to robinhome@rediffmail.com using prateek@tradeacademy.in – Send in the email and I’ll delete this comment to protect your email privacy

          • amit

            Sir i got it thank u .sir one of my friend ask u a question by mail on pl. guide

          • amit

            Sir,Wishing u all the best in ur future endeavors.

  • chetan mahadik

    Prateek sir, I have followed your Newton method combined with space theory. It is very much helpful & I have developed a great discipline judging trend reversal. I am very much lucky to follow you on trade academy.

    You made me realise that share market is a scientific world rather a gambling stuff. Thank for your valuable guidance.

    • Prateek Singh

      Thank you 🙂