In our previous post, we discussed leverage in futures trading. This post will talk about leverage in the case of buying options.
How are you leveraged as an option buyer?
Most new retail traders in India are entering the markets with “option buying strategies”. Why? Some reasons we hear:
- requires less capital than option selling
- can lead to large profits on smaller capital (”that guy made 800% return in 3 years! capital increased from Rs 5,00,000 to Rs 50 crore!!)
These crazy returns are linked to our old friend “leverage”. But this friendship comes at a price. The price is risk.
Maybe before you hear the 100 reasons why you should start your option trading journey with “option buying”, you need to understand what leverage means in this context.
An option buyer can see large percentage gains or losses from comparatively small percentage moves in the underlying product.
Let’s say we think Reliance Industries will appreciate in value today, and it’s expiry day. Let’s illustrate P&Ls on a Rs 50,000 account. Here’s two different trades we can take:
Trade A: Buy a reliance ITM call
Trade B: Buy the Reliance stock
ITM Call Buy details
Spot Price: Rs 2,400
Strike Traded: 2200 CE
Premium Paid: Rs 200
Lots Traded: 1 (250 contracts)
Case I: Reliance Rallies 10%
For our first case, let’s say we were right and the stock actually rallies 10%, owing to say perhaps good quarterly results or some other positive news.
As you can see, in Trade A the call bought and its inherent leverage resulted in a 10X return when compared to Trade B, where just the stock itself was bought.
But, what if we were wrong?
Case II: Reliance Falls 10%
In this case, perhaps our hunch or analysis was incorrect and the stock disappointingly went down by 10%.
As the stock fell by Rs 240 and closed at Rs 2,160, the strike we traded expires OTM! As a result, we lost 100% of our capital in Trade A, while buying the stock in Trade B resulted in a 9.6% loss.
This, is the dark side of leverage illustrated once again!
Buying OTM Options
If we traded an OTM option instead of an ITM one, you would see larger percentage gains, but would also require the underlying to appreciate by much more.
Let’s say we bought an OTM call option:
Spot – Rs 2,400
Strike Traded – 2680 CE
Premium – Rs 2
Lots traded: 100 lots (2500 contracts)
Assuming the same 10% movement, let’s see what our P&L would look like
Despite the stock having moved in our favour, we ended up losing 100% of our capital as the strike was still OTM! Buying the stock on the other hand, resulted in a 9.6% profit.
This is why when people talk about OTM options being ‘cheap’, it doesn’t paint the whole picture!
If the underlying were to close as it opened, you would lose the entire premium paid to take the OTM CE buy position. However, in the case of buying the stock, you would obviously close at breakeven.
Long Options vs Futures
A key difference between trading futures and long options is the risk involved. In the case of futures, if the trade goes against you, it is possible to lose far more than the margin you have paid.
However, in the case of long options, the maximum loss of the trade will be (premium paid * lot size * lots). For eg, in Trade A from above, the most you stand to lose is:
Premium paid = Rs 200
Lot size = 250
Lots = 1
Hence, max loss = 1 * 250 * 200 = Rs 50,000
This also happens to be the margin required to trade this position.