Should Retail Traders Play In Options?

The very active market in index futures has remained more or less static, while the activity in Index options has surged by some 40 times. Just over the last one year, we are seeing a near doubling of the turnover. Stock option trading has been no slough either—moving from around 6 crore plus contracts to over 74 crore plus over the last 10 years. 

So, it is obvious where the traders are today. The old school guys (like me, for example) are still sticking with futures while it is more the younger set that has dived in with both feet into the options ocean. 

Now, that was one fact. Here is another, less palatable one.  

Recently, SEBI came out with a note stating that 90% of the traders were losing money and this figure was up from 2017 (where it was around 85%, I believe). Nithin Kamath of Zerodha, too, made similar statements about traders at his broking house losing. SEBI’s data revealed that the average size of the trade had gone down quite a bit from 2017 to 2022. This would imply that most of the traders had shifted to options (where smaller trade size is possible). Hence, it would be obvious that a lot of the losers were from the options segment. 

Now, consider this. If most of the entrants were people with smaller capital, then a good majority of them would be trading long options (short options require margins to be paid). Then, the obvious conclusion would be that long option trading—touted as being ‘low risk’—was losing money.

The world over, all the books, courses, advisors wail against options shorting and advocate long options to smaller, less experienced, less knowledgeable traders. So, is this advice then wrong or misleading? 

Not really. It is just that we have to see it from a slightly different angle. The primary problem, according to me, is the low capital that traders bring with them. It is not just monetary capital—it is also lack of intellectual capital, knowledge capital and experience capital. 

The very basic point that is overlooked is that options are not linear instruments like futures and equities. Most people are habituated to think in terms of directionality when trading the markets. Options are a different asset class that have many other variables attached to them compared to futures. One major difference being Time. Options are wasting assets, unlike futures. Time erodes the value of options, but it does not do so for futures. Most new option traders don’t understand this fact and most of them are substituting cheap option plays for futures.

An example is someone wanting to play a stock 'X' directionally can do three things:

1. Buy futures (or stock).

2. Buy Calls.

3. Short Puts.

Futures (and stock) are not whittled by time whereas an option contract is. But rather than fork out a few lakhs as margin for the future, the ignorant option trader believes that he can achieve the same result by trading long options. And here, he compounds the error by taking a position in Out of the money (OTM) options. Unless luck favours this trader, the only outcome of this approach is a loss. 

This brings us to shorting options. Today, the great belief is that those that short options make money, maybe lots of it. Twitter has now become a popular playground for those who want to flaunt their shorting skills. It is now common to read about seven or eight-figure incomes made by random youngsters. No one knows the veracity of these claims but they do abound because the market is a sucker for such success stories and people lap them up. 

Unfortunately, what these stories do is to create a hype around option trading, where it has now almost become fashionable to say that you are an options trader and play the short side. So, as soon as any trader can drum up some capital, he quickly moves to shorting options. Most of them, sadly, end up losing their shirt. 

Does that mean there is no money in shorting options either? Not really. Two aspects are to be looked at here. But before that, a slight aside. Insurance companies (when they sell you policies) are actually selling you an option. You, as the Insured, pay a premium. If you pause to think, some of the biggest buildings (all across the world) are insurance company buildings. Can that just be a coincidence? In one or two places, yes. But all over the world? No chance. 

This means that there is definitely money to be made in selling options. But the key here is to manage the risks properly. Just think about the insurance companies once again. Don’t they have a 100 check points for whom they will sell the policy to? Don’t they, most of the time, go after the low hanging fruit? Are they not in control, almost, all of the time?

Now, if you come back to the option trader, is he or she really applying any risk control strategies? Do most of them even know how? I would wager a very large sum of money that they don’t. This is especially magnified when they short options. When you don’t know how to manage an option trade, the result is often a loss. 

The typical story is one of making a series of profits (small ones) and then one day getting blown out of the water with an outsized move that triggers a sharp rise in implied volatility. When time is also a factor in this equation (as happens on expiry days), the impact is far greater. One of the popular plays every week is 'Zero to Hero' trades. Most of them end as Zeros. But people play them, without fail, every week. Hope is the biggest strategy employed by a vast majority of option traders. 

And, here is where it gets more complicated. And dangerous. Technology now pervades this line so much that a very large percentage of trades are being done through automation. It is therefore impossible for the lay trader to try and compete (in execution) with the machine. Co-located servers ensure that the rates that you see on your screen are much delayed and hence, the fills you get are quite far from where you plan. The machines are running multiple algos and your small trade gets caught in the middle of one of them. Chances of you winning are therefore very slim. The big players have giant capital deployed, while you have very limited capital.  They have complex algos, designed by PhDs running on fast machines whereas you have no training and no skillsets and no execution advantages. 

You can see that you don’t really stand a chance. 

So, am I suggesting that one should not engage in playing long or short in options? Again, not really. There is a good deal of money to be made in options. But there are some basic requirements that cannot and should not be ignored.