What are the dark sides of option trading in the stock market?

Posted on 12 July 2020

There are two dark sides of Option Trading that no one talks about.


  1. Market is operator controlled.

  2. Market regulator SEBI is not investor/trader friendly rather corporate friendly.


First things first. Option Trading is always seen from a sellers point of view.


Market makers have a lot of money and they do not trade with all that money in one go. But as market develops, operators - the so called market makers keep on selling options to both sides of the market.

Check the OI of Nifty for today.


4,25,725 is 32,343 lots of Nifty which will cost a total of 250 crores in margin money. Lets assume only 50% of it is market makers which is 125 crores. And right now I am talking about only one strike of Nifty. There are multiple strikes where they are writing. So there are 100 of crores of rupee involved. Option writers take unlimited risk. Do you think they would not have lets say 15–20 crores spare to manage index heavy weights like Reliance, TCS, Infy, HDFC Bank etc or just HDFC Bank or ICICI Bank to move bank nifty to the point where they make optimum profit.


There are fund houses which deploy 10s of crores on leverage to make 1.5% in intraday alone that comes around 18–20 Lakhs in a day.


With 200 or more crores how difficult it is to manage those indexes. So market is operator controlled.


Second thing, 70%–80% of options bought expire worthless. Option selling is getting attraction among retail investors now. Recently around mid 2018, SEBI decided to increase the margin money required to trade in Index Options on the name of Protecting the Investors. A bank nifty lot which used to cost around 33,000 now costs 57,000/-. So it has doubled. Retail investors have very limited money. People that used to trade in Option Selling, their quantities decreased by half which means profits also halved. So either a retailer had to increase his margin money or get into option buying.

If he is buying option, he has already joined the 70–80% losers. If it is a new retailer, then he is also forced in option buying.


Option Buying is promoted as limited risk and unlimited reward where as it is hardly true. So when SEBI says that to protect investors they have increased the margin money, its irony and hypocrisy at its best.


There are many other dark secrets, but these two best represent the Options Trading.


Edit 1: As of 1 July 2020, margin for hedged options have reduced by 4–6 times which is a welcome step. Now it is on the individual trader to get profit from it. If margin is reduced 4 times, than it means


The new margin framework is going to create some new kind of problems in market for which option writers have to prepare

.

Full Hedged Options cost 1/6th or 1/5th or 1/3rd of naked options now. Which means retail/smart money participation will increase.


Increased quantity means increased profit. It also means increased losses in same proportion.


Increased hedge positions will not mean stability for the market. It will bring more chaos. Not everyone can win and with more volumes, there will be violent movements to either sides to shake out weak holders. Hedging does not mean that loss cannot be there. Before loss/profit is realized there can be huge volatility swings to shake out weak holders. Big M2M can scare some traders.


Which also means, any position execution will require a precise entry point for option buyer/seller now. This week we have seen Nifty move from 9900 - 10600 and then back to 10250 in mere 5 days. An option for Rs. 20, went to 200 and back to 0 in two days. This is going to be new normal now.


In this scenario, I see 2 immediate implications:

1. More volatility and unpredictable gap up or gap downs.

2. Strategy with Low Risk and High Reward had to be included in any trading system with proper position sizing.

3. Previously I used to rely on OTM options. Now I rely on better hedged ATM or near OTM options where if I lose 10 points than I have potential to earn back 50 points. For eg. previously I sold an OTM option for Rs. 30 and it hit a stoploss at 60, I had not choice but to sell an OTM option which now might be at Rs. 20/-. So I am not recovering what I lost.


What I now do is to sell higher priced options even if near the money. If stoploss of of Rs. 30 is hit, then when I reverse the position, I can still collect a premium of Rs. 60 which covers Rs. 30 lost and Rs. 30 in extra profit. R:R has to be adjusted.


And may be, sell and forget OTM Cheap Options will not work as it used to.

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Is option trading worth it?

Short answer is Yes. I have been trading in stock markets for last 10+ years and for 8 years our of that I have been an Options Trader. Trading is like any other business. You buy low and sell higher.