Options trading is a sophisticated investment tool that can help traders earn significant profits in the stock market. As with any financial instrument, the success of an options trading strategy is highly dependent on the trader's understanding of the underlying market and the options contracts they are buying or selling. A common misconception among novice traders is that options trading is simply about buying call options if the market is bullish or put options if the market is bearish. Let us discuss this with the help of an example.
Let us say that you are bullish on NIFTY and believe it will go to 21,000 this month. In an ideal world, your first thought will be to buy a NIFTY CE at an ATM strike of, say, ₹150 as an option premium and wait for the price to rise. If the price rises, you are bound to make a heavy profit, and there is no looking back. This is what we typically call a ‘naked option’, where the trader buys a call or put option with the hope of profiting from a movement in the underlying stock or index.
However, this approach is inherently flawed, as the stock market is rarely that simple, and macroeconomic indicators are often complex and contradictory. Additionally, options sellers are mostly big institutions with the smartest people devising these contracts, so the probability of the buyer making a profit is negligible.
Therefore, instead of simply buying naked options, traders should create multi-legged options strategies that involve different options contracts with different parameters, such as type (call/put), expiration date, and strike price.
Advantages of Multi-legged Options Strategies
Multi-legged options strategies are more sophisticated and provide traders greater flexibility and control over their trades. Doing so changes your payoff curve from Figure 1 to Figure 2. It is evident in the latter that you will profit if NIFTY is in the given range and your breakeven points and maximum losses are well defined on both sides.
Figure 1
Figure 2
One of the other key advantages of using multi-legged options strategies is that the trader can receive a premium without paying a single penny of option premium. This is because the trader can use their existing financial resources, such as fixed deposits, stock portfolios, or bonds, as collateral. Furthermore, multi-legged options strategies allow traders to define their risk according to their risk tolerance and minimise the amount of premium they pay, thereby maximising their profits.
Another benefit of using options strategies is that they allow traders to make profits in a wide range of market scenarios, including volatile, sideways, or even mild-bullish or bearish markets. This is because multi-legged options strategies are designed to provide traders with a well-defined payoff curve, as was evident above. In contrast, naked options provide traders with a limited pay-out and high risk, as their success heavily depends on the market's direction.
The only question that remains after this is how to put together a multi-legged strategy that works for you, and this is where uTrade Algos steps in. The platform has numerous pre-made strategy forms that help you deploy over 20 strategies in a matter of seconds. Most parameters are pre-set, but they can be customised to suit your requirements.
To Summarise,
In conclusion, options trading can be complex and challenging, especially for beginners. While naked options may seem easy and straightforward, they can often lead to unprofitable results. On the other hand, options strategies can provide greater flexibility and control over risk and the potential for higher profits. By incorporating multi-legged strategies and considering the various market scenarios, traders can improve their chances of success in the options market.
However, it is important to remember that options trading should always be approached with caution and a thorough understanding of the underlying market factors and risks involved. All decisions must be taken considering one's risk tolerance and investment goals to make informed decisions and potentially achieve greater success in the options market.
Options trading is a sophisticated investment tool that requires a thorough understanding of the underlying market and the options contracts being traded.
Simply buying naked call or put options is flawed, as it ignores the complexity of the market and the low probability of making a profit.
Multi-legged options strategies offer greater flexibility and control over risk and potential for higher profits.
Advantages of multi-legged options strategies include receiving premium without paying option premium, defining risk tolerance, minimising premium paid, and profiting in a wide range of market scenarios.
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