Playing the Russian Roulette by Selling Options

There is a new game in town – it’s called let’s play the Russian Roulette with a million chambers. The game itself isn’t new, it’s just that the players are. Unlike the real Russian Roulette with 6 chambers, in this game, you don’t know either the number of chambers that are empty nor the number of bullets that are packed.

So, how does one play this game?

Its actually very easy thanks to NSE who have introduced something called Weekly Options. Every Thursday, you wake up early, brush your teeth, sit in front of the terminal and wait for the markets to open.

Once markets are open, start selling shit load of out of the money options. Now, since these expire on the same day, you will not get much – may Rs.40 per lot or Rs.80 in case you are able to sell at Rs.2. Selling one or two of course will barely pay for a good cup of Coffee let alone lead you on to the road to riches.

You instead need to sell lots and lots of options. If you sell 100 lots, you make 4K – good but not really awesome. But what if you sell 1000 lots – 40 * 1000 = 40K, now we are onto something. And what if you can sell 10K lots?

Since you have started the day early, if markets trend in one direction, the options will crater like anything in a few minutes to an hour. You can then cover these options and sell new set of options that will give you a Rupee or Two at that point of time.

By the end of the day, all out of the money options go down to Zero and voila, all the money you made by selling those options are yours to keep. Thank the suckers who are on the other side of your trade, post your Marked to Market  numbers on Twitter and you are in business.

Now, we are on the road to happyness. Do this every week and by end of a few years, thanks to Compounding you will soon be knocking on the doors of Forbes to ask them enter your name in the Top 100 list.

Wait, you would say – Selling Options require margin and most brokers provide anywhere between 4 – 8 times the capital as exposure. So, how does one go about selling hundreds if not thousands of contracts

Well, that small issue of margins is for ordinary mortals like us – extraordinary traders get extraordinary exposure. With brokerage business having gone to dogs, the only way for brokers who want to make something out of nothing is to hope that they can give the client the exposure he is asking for and by end of the day, make it out alive.

Now, you may wonder – why do people buy those out of the money options for a Rupee or two when they very well know that the chances of it going to zero are very high?

Options are like Insurance – you buy them in the hope that if things blow up, you get back something – if they don’t, all you lose out is the premium paid. This doesn’t mean that the buyers are really hedging their risks – most likely most of them are speculators who are willing to bet a Rupee in the hope that if the market cracks, they can make multiple times their investment.

While option buyers, especially those buying out of the money options do lose out, its once again just a probability and not a guarantee. Every once in a way, when things go wrong and they usually do, you don’t want to blow up because you were too busy picking up nickels to observe the speeding monster truck that are hurtling down the road.

How big is the Risk:

There are basically two kinds of Risk.

First is the risk that markets trend one sided through the day and you get caught. While this is a general risk, the probability that you will get caught badly is not since you have enough time to adjust your position and while you may still end the day in a loss, you know it is not a killer.

The real risk is one that comes unknown – assume a big negative news flows in at 2:30. You are neck deep with shorts most of which you think will go down to zero and the market suddenly dips 10% even before you know what is happening.

While your call shorts shall go down to zero, the same cannot be said about Puts and your or rather your broker’s nightmare has just begun.

To start with, NSE imposes circuits for options which mean that almost immediately all put options will all be locked in upper circuit way below the price where they should be traded. While they will keep opening, the fastness of the move and the depth of fall means that its unlikely you will get a seller to buy back your shorts.

The bigger issue is the size of the loss. Do remember, we aren’t leveraged small. Brokers I am told are giving 40 times exposure (Don’t ask me how, they can but they are essentially bending if not breaking a few laws). So, for every Crore of Rupee you put in as Capital, you can take Notional Exposure of 40 Crores.

Yesterday being an Expiry Thursday and let’s take real prices and based on an interview, real strikes where you would have gone short.

Bank Nifty Futures opened at 25,640 yesterday. With trend being up, you decided to sell multiple lots of 25,400 put options. Now these were trading around Four Rupees and lets assume you get the same price even though your own quantity may push down the price.

Since you are a big trader, you start off with 1000 lots which yields you a good 1.6 Lakh in Premium. Yesterday was a good day and you ended the day with the options going down to zero which meant that you made the total premium.

But what if you were holding the option at 2:30 (the real trader closed out his position at 0.05, a price he could have got only post 3 PM) and a flash news triggered a market fall of 5%. Bank Nifty is now at 24,350

A 1,280 fall is bad enough, but the problem for you is that the options you had sold for a princely sum of Rs.4 are now (theoretical since they would be frozen will zero trades taking place) costing a grand price of just Rs.1050.

Since you are having a total position of 1000 lots which equals 40000 (40 * 1000), your loss is now Rs.4.20 Crores (nice round figure, Right?) .

Hell with you would be your thought – I would have placed a stop and exited well before such a force majeure ever happened.

Unfortunately, the problem with stops is that they will not get executed at times like these when prices speed off one way. Even though it takes just a few milliseconds for the Stop Order to get converted to a Sell Order, markets would have moved way away from the execution price leaving up hanging in the air so to speak.

In 1995, the Singapore head Trader of Barings Bank was in a fix. He had lost a great deal of money and something had to be done. He didn’t want to take a huge risk to recover the money and hence he executed what he thought was the safest strategy – Straddles on the Nikkei with the hope that with Nikkei not moving much, he could eat up the premium and make good the loss.

When the Gods are Crazy, even the unthinkable things happen and it was no different for Nick Leeson. On January 17, 1995 at 05:46:53 JST, Kobe was struck with a magnitude 7 earthquake. While Nikkei drifted downwards and Nick tried his best to adjust the position with the hope that a reversal would take place when things returned back to normalcy, in hindsight that was the only time he could have exited taking a loss smaller than what he eventually did.

On 23^rd January with markets getting to know the full extent of the devastation, Nikkei plummeted 5.6% which more or less close out all options of ever being able to come back. Ironically, markets did recover that day’ losses a few days later but by that time the game was long lost. But rather than cut positions, he waited in the hope of recovery which never came. Eventually, on February 23, 1995, Barings was not able to meet its margin requirements on SIMEX. The total loss accumulated by Leeson was US$1.4 billion.

Selling out of the money options for a pittance is a stupid game and what amused me was the fact that the anchor of the TV Channel covering the event was all gaga about it. Taleb has a nice chart to depict the end result of the same – 1000 and 1 day in the Life of a Thanksgiving Turkey.  DON’T BE THAT TURKEY, YOU WILL END UP IN THE OWEN.