Options are NOT the safest!

Whenever I discuss Derivatives in any batch, one of the questions I ask is - What is safer? Futures or Options?

I also ran a poll on Twitter. The response summary was this:

Invariably, majority of the participants till date have answered: Options. So I ask the why? Again, majority within them happen to say the same thing - If we buy options, then the maximum loss is LIMITED.

Then I ask - LIMITED to what? They say - whatever is the premium we pay.

And then I go on to explain why Options are arguably the most risky product in financial markets, if not used well. I attempt to do the same here.

Think in % terms!

Before I go further, I would like you to think about this situation. You have two investment alternatives to choose from. You can invest any amount of money in either of them.

Would you choose Stock A because it gives you higher absolute returns? I would hope not. Stock B is more lucrative because of higher % returns. Think of it as Rs. 1 crore to be invested in either of the two stocks. You can make more money in Stock B.

It is far more logical to think of investment decisions based on % returns rather than absolute.

The same principle applies in the world of Options. Yes, the premium you pay as a buyer is known upfront. Yes, you cannot lose more than that no matter what. Yes, your maximum loss is ONLY the premium amount.

BUT

Premium was your investment. So when you lose 100% of the amount invested, you cannot say I lost ONLY premium. Well, you lost EVERYTHING you invested in that trade. In other words, if you have Rs. 1 lakh in bank account and you use that money to BUY options & LIMITING your maximum loss - there is a decent probability that you can lose ENTIRE 1 lakh and just run out of your bank balance totally. You are bankrupt for the time being :)

Returns & Probability of Returns

Evaluation of an investment decision must factor in potential gain/loss and the probability of that potential.

What is the probability that you can lose 100% invested in a mutual fund scheme - Almost 0

What is the probability that you can lose 100% invested in a Stock - Well more than 0 but not too high (unless you are too unlucky. Even after a major scandal, Satyam stock did not fall to 0!)

What is the probability that you can lose 100% invested in Options - VERY HIGH! 50%?

Remember, when you buy Option by paying Premium, you will lose every day even if the stock is not moving. Do read about Time Decay (the time value component of the premium will fall as the option heads towards the expiry)

Let me try another way

I am sure you would agree with this ever-green famous line

Higher the risk you are willing to take, higher can be the returns you can make

Well, the statement has too many caveats. But you get the drift, right? If a product is very safe, then returns cannot be too high. You can look at Options from this angle also and understand that they are VERY RISKY.

Consider this example. The data is for TCS. Prices are as on June 28, 2019 closing.

I have considered a bullish example on TCS and hence used a 2240 Call Option (CE). Rows numbered 5 and 7 will tell you the story. You can lose 100% in CE even if the price has not fallen much. In fact, you will lose it even if price remains the same. You will not make any profit till the TCS price closes above 2302! Look at the profit potential of Options!

In futures, I have considered the Intial Margin as investment. You will start to make profits in it the moment price starts going up.

If Options were SAFE and could also give the HIGHEST RETURNS, then we should all sell our houses & our neighbor's houses to buy options!!

Arey bhai, kehna kya chahte ho?

Bottom line is simple. Buy Options ONLY if you are absolutely confident that your view will go right. You can make a LOT of returns by buying Options if you have high conviction ideas. If not (which is the case with most views), stick to Futures. You can limits your loss by using appropriate stop-losses.

Use Options with a limited part of your overall Capital. If you invest 80% of your Capital in Options, then do pray to God everyday. You might need it.

Why are a lot of first-time traders attracted towards Options?

Reason 1 - "Maximum Loss is ONLY premium" theory

Reason 2 - It is affordable! You can trade Options with even 10k. In futures, Initial Margins are higher. The minimum as of today is Rs.71,242!

So are selling/writing Options better? Well, let me take it up some other day.

If you are still here after the long post, thanks for reading!