Zerodha CEO explains – Why most retail traders lose money in option buying

Nithin Kamath, CEO and founder of Zerodha, said that over the past year he has seen the “alarming” trend in retail investor markets to turn to buying options. Zerodha recently launched a tool called Nudge to alert traders to be more careful when buying options. “80% of all open call positions at the end of each day are at a loss. Buying options ruins most retail traders. Because they don’t understand the risk of effect of leverage, reduction of the average and impact on costs, “Zerodha founder said in a tweeter.

In a blog post, he said: “Over the past year, we have seen a trend for retail traders to switch from stocks and futures to buying options. This may be fueled by the restrictions on intraday leverage on stocks and futures under the new peak margin rules. This trend is also reinforced by an influx of younger and more aggressive traders. This has been alarming for us as Zerodha. “

“In my last 20 years in the markets, I have interacted with many retail traders, in various capacities. And one thing that I have found that leads retail investors to constantly lose money is this. The main reason for this is that traders usually make a transition from trading stocks or futures to trading options. And so, they end up trading options the way they traded. actions, ”he added.

In the same blog post, he explained why most options buyers lose money, best practices for reducing risk and improving the odds of profit when buying options:

Risk management

Leverage, as it is commonly said, is like a weapon of mass destruction if not used with care. “The most fundamental risk management rule when actively trading with leverage is to ensure that you do not take a position so large that it could result in a loss of more than 5% of your trading capital. . When buying options, the total option value can quickly reach zero. This means that you should not buy options for more than a small percentage (

Decrease in options

“The most common way traders lose money is to buy Calls when they think the market is bullish and buy Puts when they think the market is bearish. they’re buying OTM options, ”he says.

The option premium is the intrinsic value of the contract and the time value. This means that the trader has to be right about the direction of the market in a big way and within a short period of time, he says.

“What is certain is the constant decrease in the value of time. This is the main reason why options buyers lose money – they are constantly fighting against time. This is different from trading. stocks or futures, where you can potentially hold the stock forever or continue to roll the futures contracts The above effect of time value is overstated because the most actively traded option contracts are ATM (At The Money) or OTM (Out of The Money) which have no intrinsic value.

If you buy weekly maturities versus monthly maturities, the time value decreases much faster.

Thus, the CEO of Zerodha suggests that “if you take a directional view of call options, always trade the monthly expiration, you will have much more time value and therefore a greater chance of profit compared to weekly trading” .

Stop your losses quickly

Losses are easier to accept when they are small, but as they increase it becomes harder and harder to cope with. “If you are trading options with more than, say, even 1% of your equity, it is important to set up a stop loss. Many retail traders find themselves stuck in this vicious cycle of hope when there is too large a loss to be accepted. Short term or intraday trades turn into long positions simply because of the loss. When you buy options, this decision to hold losing intraday positions overnight only exaggerates loss. When you buy options, there is a constant depreciation in time value, and with it, Every additional day and weekend that you hold call option positions drastically erodes the premium, ”says he.

Averaging call option positions is a bad idea

Averaging down can sometimes work when you are buying stocks and the markets are in a long-term bull market because you have the time in your favor or the ability to hold the position forever. It’s ludicrous to think of doing the same with buy / sell options when time is constantly running out on you, he says.

“The right way to trade the markets is to never be overexposed to a trade that could result in more than 5% of your trading capital. If your potential losses are limited, the chances that you are acting rationally when a trade goes. against you are much higher The average down position is performed by traders who do not want to accept their losses, and it most likely happens when the losses are too large to be accepted, ”he says.

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