Reason 1: Wrong view:
Any traders will make a loss when the underlying moves in the direction opposite to what they had expected. So,
- A call buyer makes a loss when the price of the underlying goes down and a call seller makes a loss when the underlying price goes up.
- A put buyer makes a loss when the market moves up and a put seller makes a loss when the market falls.
Solution:
Do proper research before you form your view about the underlying. You can search the Internet or meet experienced traders or brokers to discuss your view before executing an option trade.
Another way to avoid this problem is to execute combination strategies in options instead of going for the basic strategies like either buying or selling of calls and puts. If you want to know how to create these combination options strategies get in touch with us.
Reason 2: Decay in Time value:
Options lose value over time due to a decay in time value. So, the longer the option buyer holds onto the position the more is the decay in time value of the option, resulting in losses for him.
Solution:
The combination strategies mentioned above can also help you to reduce your losses arising from time value decay. These options strategies generally involve both buying and selling of options simultaneously.
The time decay results in a loss for the option buyers and the option sellers profit from it. So, when you buy and sell options simultaneously, the time value that you lose in the bought option position will be offset by the gain in time value in the short option position. In this way, your losses can be minimized.
Reason 3: Changes in volatility:
The value of options increases when the volatility of the underlying increases and it decreases when the volatility goes down. So, if the volatility goes down after you buy an option then the option premium will decrease and you will make a loss.
Solution:
To manage the risk of changing volatility you will need to understand an Option Greek called Vega. It tells us what the change in the option premium will be when the volatility changes. You must learn about Option Greeks to understand the risk-return profile of each option. This will help you to decide whether to enter a trade or not.
Reason 4: Margin shortage:
This is another common reason why option traders make losses. If you face a margin shortage or a mark to market loss after selling an option, your broker will make a margin call asking you to pay additional margins to the exchange. If you do not pay, then they will square off the position and the loss will get booked.
Solution:
Before executing a trade, you must calculate the amount of margin that will be required and make sure that you have the necessary money available. You must also consider the mark to market margins that you will have to pay if your option position runs into losses.
As a thumb rule, you should keep some extra money available beyond what you have calculated to ensure that you do not face any difficulty in managing your position if there is any margin call
Reason 5: Punching mistake:
if you make any error while sending the order to the exchange then wrong trade will be executed and it will make a loss. So, if you buy instead of selling the option and vice versa, or type in the wrong price or number of lots by mistake, then you will make a loss.
Solution:
The only way in which you can avoid punching mistakes is to be extra careful while placing the orders. As an example, instead of buying or selling several lots together, you can place multiple orders of a few lots each. You can also check the orders carefully before sending them to the exchange.
Reason 6: Heavy movements in the market:
If you sell call or put options expecting the markets to remain rangebound then you will start making a huge loss if the market makes a sharp move.
Solution:
The option sellers stand a greater risk of losses when there is heavy movement in the market. So, if you have sold options, then always try to hedge your position to avoid such losses.
For example, if you have sold at the money calls/puts, then try to buy far out of the money calls/puts to hedge your position. These out of the money calls and puts cost little but they will protect your position if there is a heavy movement in the market.
Reason 7: Gap up / gap down openings:
If the market opens sharply higher or lower than the previous day’s close, then option traders make heavy losses.
Solution:
This problem is also like the one of heavy movement discussed earlier. Hedge your position properly to avoid the risk of gap up or gap down movement in the underlying.
Reason 8: Heavy transaction cost:
You must pay several transaction charges to the broker, exchanges, SEBI, and the government whenever you trade. These include stamp duty turnover charge, transaction charge, exchange turnover fees, brokerage, and taxes. If these charges are high, then you will end up losing more than you earn from your option trades.
Solution:
To avoid paying high transaction costs you need to find a broker who can give you the most competitive brokerage. So, keep meeting various stockbrokers and understand how much they will charge from you if you trade with them regularly. Soon, you will be able to find out a stockbroker who is ready to let you trade at the lowest cost.
Reason 9: Change in exchange rules and regulations:
These may include a change in the expiry date, dividend, bonus, amalgamation, merger etc. announced by the underlying company, etc. All option traders get affected by these changes and in many cases, these may result in heavy losses for the option traders.
Solution:
You will always have to keep an eye on the change in the exchange rules and regulations so that we do not get caught off guard. Some of these changes will be within our control and others will be not. For example, if there is a change in expiry date then we cannot do anything about it and must go by the revised expiry date. However, when it comes to any underlying specific changes like dividends, we can keep an eye on the underlying and adjust our trades properly.
To avoid the risks of bonus or amalgamation and merger you can trade in index options.
Reason 10: Liquidity risk:
Liquidity risk refers to the risk that there is not enough buyers or sellers in a particular option, or the bid-ask spread is quite large. When that happens, you will find it difficult to enter and exit your position and incur a huge loss.
Solution:
To avoid liquidity risk, you need to identify options that have a lot of open interest outstanding. This will ensure that when you try to square off your open position, there will be many traders who will be ready to square off their position by becoming your counterparty. Thus, the trade will happen easily and at the right price.
We hope that by now you have got a fair idea about the common reasons why people incur losses while trading in options and what you can do to avoid such a situation. Trade options with these in mind and increase your chances of earning profits consistently.
This article is for education purpose only. Kindly consult with your financial advisor before doing any kind of investment.
