Introduction

Welcome to the world of option trading. As a trader, you can participate in the financial markets in a unique and exciting way. One of the most popular types of trading in this arena is option trading. Many retail traders jump into futures and options trading (F&O) to earn quick money. However, the outcome is just the opposite, and they end up losing more money.

Recent data published by SEBI highlighted that only 11% of traders are profitable in F&O trading. Moreover, leading broking firm Zerodha has mentioned that there are very few traders in India (i.e. much less than 11% traders who are profitable) who earn more than the fixed deposit rate. Given all this, why are we even talking about options trading? Here are a few reasons why:

• We see options as a hedging instrument that can save you from market corrections.
• With options, you can supplement your regular income even with small capital.
• With direct equity investing, you earn only in trending markets. Options offer you the versatility to earn in all markets.
• With the right strategy (as we will discuss in this series of articles), you can have defined risk (loss). Further, unlike direct equity investing, you can reduce your loss as well by following the right adjustments.

In this series of articles, we will cover only the practical aspects of options trading. Therefore, it is assumed that you understand the basics of options as a financial instrument. If you are new to this subject and interested in learning, we recommend going through the option module on Zerodha Varsity (https://zerodha.com/varsity/module/option-theory/).

To succeed in trading, you need three essential things. These are:

• Right Mindset
• A trading plan/strategy which you can stick to
• Proper Risk Management

In this article, we will focus on developing the right mindset for trading in options before we jump into strategy and risk management in subsequent articles. So, let’s get started.

Option Trading and Insurance Business

Option trading has a lot in common with running an insurance business. It’s true! And once you get your head around this idea, the rest of option trading can become a lot easier. By understanding this principle and proper risk management, one can earn consistently through options trading. This is what your objective should be as there is no get rich quick scheme out there in the market and anyone who is selling it is just trying to take away your hard-earned money. Don’t fall for that. SEBI data speaks for itself. Now let’s get back to the mindset development

Before we discuss about options, Let’s quickly understand the business model of an insurance company and how it makes money.

The insurance companies make money by taking risks from others in exchange for a premium. For example, if you own a vehicle, you have car insurance that protects your car against a big loss like theft or accident. The insurance company collects a premium each year to protect you against the big loss. The insurance company pays you to make you whole.  The same goes for life insurance and other products

For an insurance company to function and make profit, it must know what risks it is willing to insure. It also needs to know how much premium it needs to charge to be able to take back the risks and still earn a profit. Basically, they need to ensure that premiums that they are charging or earning from their large customer pool should be more than claims that they are likely to have. To ensure that, it will need to know the car-theft statistics and accident statistics for your car’s model and year. Using that information, the company can price coverage and charge a premium that allows the company to make a profit on the large pool of car insurance it writes. 

Just to express this mathematically, here is an example of how an insurance company makes money selling automobile insurance.  

Let’s assume that each year ABC Auto Insurance Co. Insures 10,000 cars with an average value of INR 500,000 per car, and it charges on average INR1,000 annual premium for each car. Each year it has on average 1,000 claims where the average cost of a claim is INR 5,000. Looking at the insurance operations, ABC Auto Insurance Co. earns a profit of INR 5,000,000. 

This is how a gross Profit and Loss summary looks: 

Of course, there will be administrative overhead beyond this gross profit. Also, while ABC is waiting to pay out claims, it makes more profit from float income and investment income. Insurance companies invest the capital into market linked instruments to earn additional income. We will not get into this. But this is the business model of an insurance company.

Insurance companies collect a lot of data, use statistical models to estimate the likelihood of an insurance claim and then charge the premium accordingly and manage the risks efficiently. So, Company who runs an insurance company, becomes insurance seller and customers like us who purchase insurance are insurance buyers.  Between the two, we know who is more profitable.

Option Trading

Now that you know the business model of an insurance company, let’s come back to our core agenda of options trading. Options are a contract on an underlying instrument. For example, consider the stock of Reliance Industries (“Reliance”). Assume Reliance is trading at INR 2,500 (Spot Price) on 30th April 2023. Market participants/Traders will evaluate the possibility of closing price of Reliance in May series, say 30th May. Now assume you are trader and based on either technical analysis, fundamentals, past returns, etc believe that Reliance will not cross INR 3000 in May series.

To benefit from this analysis, you will sell Reliance 3000 (strike price) call option and collect some premium (say INR 30 per lot). So, if Reliance closes below INR 3000 you will earn INR 30 per lot profit. Now another market participant based on his/her analysis believes Reliance will cross INR 3000 in this series. So, he will buy an INR 3000 strike price call option and buyer and seller will enter in the option contract. Here, they are betting on the outcome whether reliance will close above INR 3000 on the expiry date. In our car insurance example, insurance buyers and sellers are betting on the fact whether any claim due to accident will arise in a year or not.

Now, as we know that insurance sellers have a higher likelihood of making profits. So, here option sellers also have more likelihood of making profit. But before we get to this point, let’s quickly understand the drivers of option pricing and how a trader believes that INR 30 per lot premium is sufficient to take the risk. Remember on any single trade, Option seller can theoretically have unlimited loss (if you don’t know why, then please refer Zerodha Varsity module).

Option price is impacted by 4 main variables also known as “Option Greeks”. These are “Delta”, “Theta”, “Gamma”, “Vega”. You can learn more about option greeks from Zerodha Varsity but here we will explain how it impacts option pricing.

Delta: Delta is the rate of change of options premium (price) based on the change in price of the underlying. As the price of the underlying moves, delta changes. The value of Delta ranges from -1 to 1. ATM (at the money) options have delta of ~0.5 while deep ITM (In the Money) options have delta close to 1.

Theta: Theta is time decay. Option price decreases as it reaches expiry date. Theta always works in favour of an option seller

Vega: Vega is the rate of change in options price based on change in volatility. Increase in volatility works against the option seller and vice versa

Gamma: Gamma is the rate of change in Delta. It is the second order derivate of price movement.

Now, one out of the 4 variables i.e Theta, always works in favour of Option seller. If you trade Delta neutral strategies or non-directional strategies, then another variable is addressed. However, as the price of underlying security moves, strategy delta will change and that needs to be managed. We will discuss this later when we cover trading strategies. Vega is uncertain, however with experience, if you believe if the implied volatility (IV) is higher than historical volatility and IV will go down, then one can initiate option selling, which will benefit from IV crush

So, as insurance company look at lot of historical data to estimate claim probability to price the premium, Options traders have following tools in their arsenal to make risk reward favourable:

• Technical Analysis (TA): Using TA, one can find out strong demand (support) and strong supply(resistance) zone. This will help us to know where price will not cross on expiry. Depending upon where the market is one can then initiate writing put and call option to increase odd of success. We will explore this using a few simple setups in subsequent articles.
• Option Chain Analysis: Option chain analysis offers an insight into the positioning of large and institutional traders. One can also use this to identify strike prices which are going to expire worthless on the expiry date.
• Managing Greeks: As mentioned above, while selling you can make Greeks work in your favour. Remember for an option buyer to make profit, the underlying must move in that direction in a specific time (as theta works against buyer) with no change/decline in volatility. As markets trend only 20-30% of time, the ODDs are heavily stacked against the option buyers.

One can use the above framework to start the option trading (selling journey). It’s not that easy as many social media influencers, workshops, online seminar make it sound. There is no holy grail or magic strategy as advertised. Do not fall for that. It’s a serious business for which you need to develop a mindset, proper risk management system and finally a strategy or trading plan. If you are willing to commit towards learning, then subsequent articles should help you in guiding towards the right path.

We will cover the strategy part and how we normally trade options in subsequent articles. We will also share some common low risks strategies which has worked well for us and has favourable risk reward.

Let us know your comments, suggestions, and feedback in the comment box below.