Are options complex instruments? They indeed are and it gets even more complex on the day of expiry where the payoff is too sensitive to the expiry level.
Every expiry, traders commit repetitive mistakes and it is time to master a few and stop them from hurting you again.
Evade the last minute ‘hope’ & ‘greed’
A thumb rule for risk management should be to not lose more than what you could have made and a stop loss for maximum double the premium should keep the probability in your favour in the long run. Remember, most of the unsuccessful traders fall prey to ‘outliers’ and not small cumulative losses.
Trim your greed:
Let’s take an example. Option sold at Rs 50 at 9:30 am is quoting at Rs. 2.5 at 11 am on the day of expiry. Yes, you did expect the option price to fall to zero (0), but the fact is that the option price has corrected by 95 percent and the expiry still has enough time.
It’s the game of probability; payoff to the additional 5 percent return may not justify this risk of losing an unknown value. If the decay has happened prematurely, feel blessed and move on.
A good habit would be to act sensibly and book profits if the uncertainty is high and option prices have corrected in your favour by over 90 percent.
Reference Future Prices instead of Spot in the last 30 minutes:
It is true that option prices will expire with reference to the underlying, but at the same time remember it is a 30-minute Volume Weighted Average Price and the Spot doesn’t trade on VWAP but its derivative does.
The Spot price of the instrument is completely free to move independently but as the instrument approaches expiry, market participants track the ongoing VWAP and trade in expectation of expiry.
The thumb rule here is to trust the market and reference the Future Price. This price can help complete any pending action for a last minute reference trade with a higher accuracy.
Don’t get caught up in the last minute mispricing myth:
The probability of a large gold coin lying on the floor for you in a hall full of people hunting for one with sophisticated lenses is very unlikely.
Let’s admit this: there are arbitragers looking for mispricing with automated systems and there barely exists one for you. An option trading below its intrinsic value is still the visible fact but not the real truth.
At times Spot prices may move up whereas the VWAP may still remain low and option prices will refer the weighted average leading to visible mispricing.
A reality check would be to relate it to its ongoing future price which will certainly help you avoid these.
Square-off ‘Long In the Money’ Options before you realize it went to taxes:
Every expiry multiple traders commit the mistake of not squaring off ‘Long In the Money’ options and hold it until expiry. Not knowing the correct tax calculation may not just take away your profits but may lead to a severe loss too. There is a difference in tax calculation which you must know.
Example: Nifty Expiring around 10,600 and you hold a 10,400 call bought at Rs 180 which is now priced at Rs 200. Lot size is 75.
Tax (STT) if sold before getting exercised: Rs. 7.5 i.e. 200 * 75 * 0.05% (Premium * Quantity * 0.05% STT)
Profit and Loss (P&L) is Rs 1,492.5 assuming no other expense
Tax (STT) if exercised/expired: Rs. 993.75 i.e. (10400 + 200) * 75 * 0.125% ((Strike Price + Premium) * Quantity * 0.125% STT)
P&L is Rs 506.25 assuming no other expense
We learn that in the second case 66.25 percent profits are paid away to taxes.
The author is CEO & Head of Research at Quantsapp Private Limited.
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