The curious case of cheap options

Doubling / Tripling money in a short time frame is every trader’s wet dream. For many with a great 20-20 (hind)sight, they see such opportunities everywhere. If I had bought X Call yesterday, I could have easily sold it for double today. Hold it for a few more days, it would seem that the option did not stop at just doubling or tripling in price but went on and on and on (like Havells switches I assumeJ ).

Options at the very basic level enables a buyer is to get the right but not the obligation to buy certain shares at a certain price in exchange for a small premium paid to the seller (who takes the risk). The problem with options though starts with this “small premium”.

A 10 Rupee option is not cheaper compared to say a 100 Rupee option though the investment is lower in case of the 10 Rupee option vs. the 100 Rupee option (assuming both of them are of the same stock).

Logical probability thinking makes us believe that a 10 Rupee option has more chances of doubling than say a 100 Rupee option. But the reason an option moves has nothing to do with the price of the option and everything to do with the movement of the underlying stock / index.

Option Price is dependent on

1. Intrinsic Value (Delta)
2. Time to Expiration (Theta)
3. Volatility (Vega)
4. Interest Rates (Rho)

The aim of any trader / investor doesn’t end with making profits but is about creating wealth. Wealth is created primarily by long term growth of the underlying business (in case of stocks) as well as by the affect of compounding.

Wealth is in-turn created not just by making the right choice of stock but also requires one to allocate the maximum amount of capital so as to maximize the opportunity. One reason why Real Estate is a wealth generator is that the allocation is big (compared to the Individuals Networth).

Assume for instance a person with liquid assets of 1 Crore who buys a site worth 1 Lakh. X years down the lane, the site has given 10X return. But if we assume the persons networth has remained at 1 Crore, the total return generated comes down a piddly 10%.

The same problem confounds the option trader (Buyer in our case) as well. Assuming a trader has a capital of say 1 Lakh, what is the amount of money one should invest in an option is a science in itself. Bet too small and even though you may have a multi bagger in your kitty, your net return will still be small. Bet too large and the option loses value (it’s easy for options to lose 50% of their price (other than deep in the money options) in no time and you end up with a severely eroded capital that restricts the amount you can bet the next time around (unless you are one of those guys who regularly replenish your capital from your Salary).

A friend of mine recently asked me to test a premise which seems to have been advocated by one of the self styled analyst on a Kannada Channel.

The strategy in itself is pretty simple. Buy a strangle (150 to 200 points away from current price) on Nifty on expiry day and sell when either the investment doubles or 10 days (or day 10 of month, whichever is later) passes (reason for selling on day 10 is that as the day to expiry nearly, the pace of the option price fall accelerates).

 There are some good months when the returns have been pretty awesome. For example, in the month of March, by day 8, the price of the strange for which one would have paid around 70 bucks would have increased to 118 (a gain of around 68%). Or take the month of August. A strangle bought on the last day of July series and costing Rs.115 would have been worth around Rs.274 on 6^th August giving a return of 138% over the span of 12 days (inclusive of holidays).

But only if life was so simple J

Consider the month of November 2012. A strangle bought using the same logic would have seen a decline 53% in the investment. Same was the case in the next month (December 2012) as well. In just 2 months, any person who started trading the strategy with a capital of X would have seen his capital deteriorate to X / 4 by end of just 2 months. Recovering that would now require the set to Quadruple in price – something that doesn’t happen often   

Options are nothing more than Insurance though the ability to trade them makes them one hell of a product to gamble with. Buying cheap options seem like an easy way to make money, but my experience has told me that there is no free money available for anyone to pick up. Both buying and selling options (naked) will for sure result in ruin of capital in the long term though timeline may differ based on the small factor of luck.