Option buying is better than option selling

Asit Baran Pati | An options buyer journey to financial freedom

Option buying has got a bad name in the trading community mainly on account of the high rate of failure. Asit Baran Pati explains what it takes to make option buying hugely profitable.

"Do not judge me by my success, judge me by how many times I fell down and got back up again."

These words from Nelson Mandela are true for every successful person, be it a businessman, sportsperson, musician or a trader. It is especially true in the case of Asit Baran Pati @asitbaran, who rose like a phoenix from the ashes of his creation.

From a well paying Investment Banking job to live off his mother's pension money, Asit has seen it all. It was his confidence and persistence in search of a winning formula and sticking to it that made him a successful trader. The taste of freedom between jobs when he attempted to trade fulltime, was his driving force.

A short term momentum trader and a scalper, he is among the few successful options buyer in the trading community. He has strong views on options trading and why retail investors need to be aware of the risks involved.

Apart from trading, Asit likes to listen to western classical music. He confesses that he is an audiophile and collects different headphone and when he has some free time goes out looking for Vinyl records.

In this interview with Moneycontrol, Asit Baran Pati talks of the ups and downs in his trading career and how he finally made it.

Q) Can you tell us about your journey to becoming a trader?

A: I have been on the research side of the Investment Banking field for the most part of my professional life. After completing my BCom Hons from Odisha I moved to Delhi to do my MBA in Finance after which I worked in various research firms conducting sector research.

I later moved to Hyderabad where I worked for a KPO (Knowledge Process Outsourcing) firm called Office Tiger where I worked for international clients like Blackstone and JP Morgan. After two years I moved to a company called UBS Captive which was being set up in Hyderabad. I worked there for nearly seven years and was actively involved in the Investment Banking research process preparing financial and valuation modelling. This was a high-pressure job where we used to work for 12-14 hours every day.

Though we were compensated well for the sacrifices we made in our social life, the job was taking a toll on me. I remember a time when on a Diwali day we were asked to work the entire night because the analyst had a presentation the next day in the US. I along with my team, sat down to complete the job. It's for days like these when you question yourself as to what is important in life. For me the answer was simple – freedom to live my life the way I want. That move towards freedom was about to start.

2012 was a watershed year in my life for more than one reason. I lost my father to cancer after an arduous 8-9 months of battle. We were also blessed with a pair of twins during the year. And finally, it was also the year I started dabbling in the market.

My father who was a bank manager was a regular investor in the market, but till the time he was alive, I rarely looked at it. I guess he passed on the baton to me.

During the initial period, I dabbled in the cash and futures market. Though my work experience was on the fundamental side I was never a patient investor. I preferred the shorter version. My interest in the market started growing as I steadily started making money.

Looking back at it, it was plain and simple beginner's luck. There was no strategy that I was following. I picked up a stock that was moving or heard some recommendation on TV and traded them.

Just before the 2014 election, I had bought some shares and few call options in the market. The sharp rise post-election results increased my investment by almost three times in a matter of one month. This event got me interested in the market.

By now I was trading big quantities in the derivative markets and making good progress. I was making a month's salary in a matter of a week in the market. There was a phase when every alternate day my profits were equivalent to my month's salary. This period made me feel invincible and I used to think that I was good at my job and also good at trading.

I was so carried away that I was trading with intra-day leverage of 10-15 times. Greed took the better of me. If I was making Rs 1 lakh in a day I would chase a target of Rs 1.5 lakh but end up losing the entire profit.

Looking back I had no clue how I was making money. As is always the case, the law of averages caught up with me and my losing phase started. I lost my capital and savings in the market. To make matters worse, I left my well-paying job at UBS Captive to concentrate on my trading and recover my money.

But my losses just would not stop. I kept on losing money regularly. The more losses I made the more aggressive I became. Revenge trading only made matter worse for me. My ego did not allow me to think rationally. I was good at my professional career and I felt that I would be good in the markets too. Accepting the fact that I had failed did not come easy.

I tried everything in the market to recover my money, including paying for those pesky market calls from Indore. Nothing worked but there was a lesson in all this. It taught me what does not work. So I decided to find what does work.

I was forced into reading books and blogs to prepare myself for the second innings and take trading as a serious business. The book that changed my life and my psychology to trading was Alexander Elder's Trading For A Living. The Disciplined Trader by Mark Douglas and Trading in the Zone by Ari Kiev were the other books that had a big influence on me.

But getting back on my feet would take some time. I was flat broke, I had borrowed money from family and friends and had no source of making money. There was no job nor any money left in the bank account and I had the monthly EMI to take care of apart from other expenses.

The only thing I had was the support of my family. Though they did not know the intensity of my problem, I knew that I could count on them.

I was always confident that I had enough skill and experience to get myself another job. I started looking for one and found it in Bank of America in Gurgaon in June 2015. Such was my state of helplessness that I did not have money to go to Delhi and had to ask my mother to give it to me from her pension fund.

Looking back, had I not been completely broke with my self-esteem completely down, I do not think I would have done the kind of research and back-breaking work that I put in.

I borrowed money from my mother to book a train ticket to Delhi from her pension account. I lived off my mother's account for 2-3 months. For the first few months in Delhi, I stayed at my friend's place as I could not afford a rented house. Over the next few months, I could save enough from the new job to take care of myself and my family. But these few months of 2015 were the defining moment in my life.

With some stability on the operational front, I was back looking for opportunities in the market. The job pressure in BankAm was lower than in UBS. But I had tasted freedom and was longing for it again. The difference this time was I knew what I was doing and had my systems and strategy in place to make money.

More importantly, I knew that trading is a game of psychology and discipline. Technical analysis and strategies are secondary. How you think is how you trade. If you need to succeed in trading you must first change how you think. After a couple of years at BankAm, I was back trading full-time.

Q: What all do you trade and how?

A: I am an option buyer which means that I am dependent on momentum and trend to make money. In options, I generally trade the weekly Nifty and Bank Nifty options. I also trade stock futures.

There are two main types of trading that I do. First is what one may call a BTST or a buy-today-sell-tomorrow trade which is based on momentum and the second is scalping. Signals for both these trades are generated by a system.

Though I have a decent knowledge about charts I prefer to look at data like open interest built up, option chain, implied volatility, put-call ratio, etc. Apart from these, I have a series of indicators that help me navigate the market.

Selecting an indicator is important. Many traders use multiple indicators which are overlapping and essentially confirm what the first indicator is saying. While no single indicator will tell the entire story, the goal is to integrate the information that indicators provide to get a better picture. I use indicators that are grouped under trend and momentum, breadth, volatility and volume category. The entire gamut of indicators helps reduce the clutter and present to me a multidimensional view of price behaviour.

To get a comprehensive picture I use these indicators on multiple time frames ranging from 15-40-75 minutes to 1-3-6 hours. Different timeframes provide useful information on differing relative volatilities.

The extract of these indicators and data are numbers which I rank. My system uses Bull and Bear ranking to each instrument. As there are 15 indicators that I use, during the phase of extreme bullishness the rank would be +15 and of extreme bearishness, it would be -15. So if Bank Nifty has a rank between +12 and +15, I would like to buy Calls and if it is between -12 and -15 I would like to buy Puts. The quantity that I will trade also depends on the ranking that the system throws up.

In the recent past, there was one day when the system gave an extremely bullish signal of +15, that was also the day I made my biggest profit. This was the day the finance minister announced the corporate tax cut. There was also a time when the system could not prevent me from taking a sizeable loss. I had carried my long call position overnight and the next morning there was this news of air-strike. Being an outlier event, the system cannot be blamed for catching it. I booked a loss the next morning which was recouped in the next two trading days.

No system will ever work fully. The game of trading is not about guaranteed profits but about the probability of making a profit. This is where option buying comes in.

Q: Why have you selected options buying over options selling, which is what most traders do?

A: There is a misconception that buying option is a losing trade. Let me explain the concept of option buying.

The 'Probability of Profit' also known as POP in the trading world is only around 30 percent for an option buyer. POP is the probability of an option closing ITM on expiry. It also indicates that a trader will make a profit or barely breakeven only 30 percent of the time. This is also the reason why option selling is catching up as their POP is 70 percent.

In trading, POP is all that matters. For an option buyer, it goes down with time and for an option seller, it increases with time. Thus, for an option buyer, it becomes imperative to trade only when the momentum is good. The Greek gods that an option buyer can worship are Delta and Gamma while Theta is their biggest enemy.

An option buyer should not hold his position for a long time as Theta or time decay starts playing on the position and erodes its value. Secondly, an option buyer should buy such an option which has more intrinsic value than extrinsic value – which means a slightly in-the-money (ITM) contract. Further, your timing should be such that the momentum is strong and is building up. One needs to exit the trade as the momentum slows down. The only way an option buyer can end up with a winning trade is if the underlying stock or index moves significantly in his direction.

If you are buying option in a trending market the Greeks Delta and Gamma in an option premium will ensure that they not only nullify the effect of Theta but also overpower it. I always enter a trade where the momentum is about to enter an active zone.

The strikes that I chose to trade have a delta value between 0.3 and 0.6 and tend to avoid deep ITMs. I prefer to buy options with a high premium and sell them higher.

If you time the option of buying right and select the right strike to trade, there is nothing that is as profitable as options buying. Unfortunately, most retail buyers tend to buy out-of-the-money (OTM) options and hold them till expiry which ends up worthless.

The basic idea of being consistently profitable in option buying is not to fall into the trap of option sellers. In option buying the margin requirement is low, its risk is low but so is the POP. To keep the odds in my favour I keep on rotating the strikes as per the movement of the index.

As compared to buying option selling option is a high-risk game, similar to selling earthquake insurance. All it takes is one earthquake to wipe out the profits of the insurance company.

A quote from Nicholas Taleb's book 'Fooled by Randomness' explains the risk associated with options selling. He says "a 99.9 percent chance of winning a $1 bet over 1000 bets is not worth it if there is a 0.1 percent chance of losing $10,000. Over 1,000 chances you will win $999 but the one losing chance will take away $10,000."

A day like the one on which corporate tax cut was announced would be enough to wipe out an option sellers profit made throughout the year.

Even the best and most knowledgeable option sellers could not save themself from these black swan events. The point here is we need to cover our bases for an unforeseen event. While in option buying the losses gives the buyer a chance to come back, an option seller can get wiped out.

James Cordier from Optionsellers.com and author of 'The complete guide to option selling', one of the most popular sites on option selling, wrote to his investors recently about 'Catastrophic loss event' that he not only lost all their money but that they would also owe money for margin calls. This was after the sharp move in Natural Gas which caught him unaware. If such knowledgeable traders can go belly up, a retail trader has reason to be worried.

Q: What is your options buying framework?

A: There are a few criteria that need to be taken into consideration before buying options.

Apart from the strike selection that we discussed above, implied volatility (IV) also needs to be looked into. If IV is high, ATM buying should be avoided. One must then buy shorter-term ITM options.

Timing the entry is very important. While buying options, the objective is to minimise the amount of time of exposure in the market.

Volatility skew is another thing to note which is used to identify opportunities to buy cheaper options. A negative skew for buying call options is preferable as it implies that IV increases as we move from higher strikes to lower strikes. Thus if you buy a call option and everything works in your favour and the call option moves deeper in the money the IV's will go up taking your option premium higher.

The ideal situation to enter if you are a buyer of a call option is to buy it on a pullback.

Coming back to my momentum trading strategy I start building my position between 1.30-2.00. I will scale into my position as it moves in my direction. If the position is not moving in my direction and starts to hurt me I will be out of the trade.

Since the move is sharp towards the end of the day, my premise is it will continue to do so at the start of the next day.

For each day I have a fixed profit and loss target. After these targets are achieved I am sitting on the sidelines or taking small scalping trades. If I have earned, say Rs 1.30 lakh during the day as compared to my target of Rs 1 lakh, I will use the extra Rs 30,000 as my stop loss to the scalp.

Q: How do you scalp in the market?

A: Scalping has helped me become a better trader over time. I do scalping only in index options on account of high liquidity in them. There are small windows of opportunities to scalp every day which I try to capture.

I start nibbling in a trade with a small quantity and only when it moves in my direction I will add to the position. Say if my signal is generated at Rs 200, I will add to the position at Rs 230 but if the option premium goes down to 170 I will start reducing my positions.

Having said that scalping is not easy. You have to be cold-blooded in taking these trades. There may be an occasion when you have exited the trade and it still keeps on going up, you need to be happy that your target is met and that this was only a scalp trade. Changing the strategy is an easy temptation to scalpers and probably the reason for their downfall.

I use four indicators for my scalping trades – Supertrend, MACD (moving average convergence divergence), ADX (Average Directional Index) and EIS (Elder's impulse system) which helps speedy exits.

I will hold on to the position until at least two of the indicators give me a sell signal.

Q: What would you like to tell a retail trader struggling to get his act in place?

A: Trading is 20 percent theory and 80 percent practical. No amount of reading and attending seminars will help you if do not start trading yourself. It has to be experienced. When you are in a trade the trainer would not be there to help you always, you have to learn to fight your way out. To do so you should have your trading plan in place.

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