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Understanding Options biography for error-free trading

The most crucial thing to learn in this understanding of Biography of Options is to gauge whether or not we will make money with the option trade given the longevity of my view.

SHUBHAM AGARWAL | 25-May-19
Reading Time: 3 minutes

undefined Options have evolved from being just instruments of risk containment to fancy vehicles for trading. Well, at least we can say that about equity options.

In this attempt of creating a trading utility out of a pure hedging instrument, there is a tiny yet crucial detail that one must understand, which is the biography of an Options or in other words what happens during the life of the options.

Typically, when one buys a Call Option, the driving force is that there is a sunk cost a.k.a. premium which is the maximum loss and the profits are unlimited.

The first instance of error here is that while we do affirm the availability of the profit potential, we hardly sync it with the longevity of our own view.

So, the most crucial thing to learn in understanding Biography of Options is to gauge whether or not we will make money with the option trade given the longevity of my view.

Because trading views can have a life of a couple of seconds (There are few techies who do high-frequency trading) to a few hours to a few days.

Now let us take a trade. The stock is trading at 100 with the expectation of going up to 102 while on the downside containing itself to 99. Typically, if I were to trade this view in Options, I would go ahead and Buy a Call of 100 Strike.

This Call could be trading at 2.5. If my view is that the stock can go up by Rs 2, on plain expiry perspective, I will still be making losses. But that does not happen because the sensitivity to the price pushes up the premium during the expiry and brings it up possibly to 3.5 when the stock moves to 102.

This is where the biographical analysis of an Option is required when the view on underlying overlaid on it, which may not have the same longevity as the Option (days to expiry).

So, pick any calculator for Options, input the current stats (underlying price, strike, premium etc.), we would get the volatility figure.

Plug in the expectation (time and price) along with volatility and figure out what the premium of the option would be if the stock under consideration moves from point A to point B after the passage of X amount of time.

The Answer is that when the premium is compared to the current premium and it makes sense to you economically, only then take the trade.

For understanding, the biography of Option or even portfolio of Options, there are many sophisticated software. All built because the trading in option requires us to understand how they behave during their lives and not just how they end up on the day of expiry.

Now, chances are that if we test the same 100 to 102 view with the life of trade increased to 7-10 days, the singe Call Buy of 100 may not make money. Hence, while evaluating, evaluate combinations as well.

So a textbook strategy of Bull Call spread could be evaluated where I would evaluate the Premium performance of 100 Call as well as 103 Call.

And, if we were to Buy 100 Call and Sell 103 Call with the same underlying expectation, would we make any money?

In a nutshell, it is critical while trading Options , to set a time and price expectation of the view and then understand the selected Option's behavior over that period before freezing on a particular option trade.

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SHUBHAM AGARWAL is a CEO & Head of Research at Quantsapp Pvt. Ltd. He has been into many major kinds of market research and has been a programmer himself in Tens of programming languages. Earlier to the current position, Shubham has served for Motilal Oswal as Head of Quantitative, Technical & Derivatives Research and as a Technical Analyst at JM Financial.

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