A professional option trader must first become a net seller

The logic is simple. The nearer you reach the expiry date, the less is the risk. This phenomenon of decreasing price with time is called Theta decay, which is nothing but the rate of decline in the value of options over time

“Vyutpann Ek Aavashyakta-janya Vittiya Yantra Hai, Samajh Leejiye;

Nivesh Pariharya Hai, Bin Peshevar Salaahkaar Ke Kabhi Na Keejai”

Translation: Derivative' is a need-based financial instrument, please do understand; this financial terrain is too choppy, only consummate ones should land.

Security derivatives are ideally used for hedging purposes. But as an instrument that also generates income, it is quite popular; although that route is extremely risky and requires excessive caution and enough expertise. Only an adequately knowledgeable person, who has experience of derivative trading for years, is likely to succeed in generating income reliably and steadily for a considerable period through this.

The term derivative refers to a type of financial contract whose value is dependent on an underlying asset, group of assets or benchmark. Common derivatives include futures contracts, forwards, options and swaps. The term option refers to a financial instrument that is based on the value of underlying securities such as stocks, indexes, and exchange traded funds (ETFs). An options contract offers the buyer the opportunity to buy or sell—depending on the type of contract they hold—the underlying asset. (Investopedia.com)

Though there are many types of derivatives, for the sake of simplicity, I will dwell deep about the easiest and the least risky way of derivative trading, that is options trading:

Execution of Option trading:

1 The foremost is that you must buy subscription beforehand of a facilitator like ‘Opstra’, ‘Sensibul’ and the likes, which can give you real time calculations of option greeks. This is crucial as it can save you from probable losses. Please mind that an application like ‘Opstra’or ‘Sensibul’ is essential but is only a supportive application for Option trading. Before getting this, you must have subscribed to a real trading platform like Zerodha, Upstox, SBI Caps or others.

(Note: Option Greeks are financial measures of sensitivity of the option's price to its underlying asset like Delta, Gamma, Vega and Theta)

2. Option trading on index like Nifty is safer if you keep the Greek calculations balanced at each point of time (say after every two hours), which is quite possible.

3 Delta of your option portfolio should be near 0. Though from 0 to (-5) is considered a safe zone.

4 Options far away from the current figures are considered much safer. It means that if Nifty is hovering around 22000 at some point, then you may sell the Call option of say 24000 and the Put option of say 20000 of the same expiry dates.

5. The nuance lies in the trade-off between the margin money ceded till expiry and the probable profit % likely to generate on that. If in the given timeframe, this profit % (annual rate) is say double that of fixed annual interest rates offered by banks then you may consider going for it. Within a fraction of seconds, you are supposed to decide whether the margin money asked is less than the allowable limit for you or not. The less it is the better for you in terms of profitability.

(Note: Margin money asked is instantly displayed when you attempt to sell an option. Profit % is calculated by dividing the premium amount by the margin money. This is because the whole premium amount on sold options remains with you as your profit after successfully crossing of the expiry date)

The above strategy, in my view, is the safest way of generating money through option trading for the beginners. For consummate option, there are many strategies that are practiced, which they mostly use for Option trading in securities or indexes. These methods may be Iron Condor, Strangle and Butterfly Spread, among others.

A professional option trader is usually a net seller. It means though he might have both bought and sold option of the same stock and same expiry date at different strike prices, in totality, the premium gained by him should be a positive quantity. There are two reasons why the professional option trader is usually a net seller:

If all the other factors are controlled, then the price of an option decreases by time. The logic is simple. The nearer you reach the expiry date, the less is the risk. This phenomenon of decreasing price with time is called Theta decay, which is nothing but the rate of decline in the value of options over time.

The rush in buying is more (making it overrated) than in selling because the latter comparatively needs huge margin money than buying which requires just the option buying amount. Most of the people think that buying is the safer route since one must put very less amount say around Rs. 3,000 in comparison to lakhs in selling as the margin money. But this notion is not true. In real sense, sellers have much more probability of ending in profit than the buyers.

Here is an eternal catch. If you buy the options, your risks are limited to the premium amount you spent, and the possible maximum profit is unlimited, which is just the reverse in the case of selling. It implies that if you sell options, your risk is unlimited and possible maximum profit is limited that is to the premium you have received. And still, what is recommended to a professional option trader is to become a net seller. But of course, dealing with unlimited risk in hope of very limited return does not bode well for beginners. Even for knowledgeable ones, it is a tempestuous ride.

If the foregoing makes any sense to you, you can think of trading in derivatives and if is Greek and Latin to you, then better stay away from it.

(The writer is senior Vice-president, SBI Funds Management Ltd; Translation and content by Hemant K. Das, MBA (NMIMS, Mum) a Mumbai -based option trader and financial consultant)

(Disclaimer: This article is written only for educational purposes and the writer, or the blog will not be responsible for any loss incurred by someone because of it)