Dysfunctional risk removal with Option strategy improvement: Shubham Agarwal

Option as an instrument was created to manage risk. Bringing this into the context of our equity options trading, the Calls and Put that we buy from the Sellers of the options, are in principle taking away the risk element from us Buyers of the options. Similarly, when the shoe is on the other foot and when we are on the Sell-side of the options, we take disproportionately higher risk compared to the reward (the premium inflow).

Example:

With Stock X Trading at 100

If we Sell 105 Call at Rs 1

Our Reward is 1 at its Maximum

Our Risk = Any amount beyond 105 at which stock closes on the day of expiry.

Limited Risk & Unknown (Cannot say unlimited) Risk.

Now such Sell options trades are resorted to in many option combinations as well. Meaning not just an isolated Sell trade but one Buy option and One Sell or one Buy Option and Multiple Sell and so forth.

The improvement that we will talk about here will work with a simple adjustment to our options trades. This will be achieved by monitoring the trades for Dysfunctional Risk and Getting Rid of them.

Some of the aptest use cases are the following 3 kinds of trades done at the beginning of the expiry (when there is the majority of time left for expiry compared to time passed).

1. Option Spreads:

Typically, option spreads are Buy and Sell position in the same kind of option in the same stock and in most of the spreads same expiry.

Spreads reduce the cost of the Options Trade and thereby the outflow at the cost of restricting profit potential only to the extent of the Sell strike. Oftentimes Spreads are resorted to when the Conviction is low.

In such situations, if the stock/index goes in the unfavorable direction, we will start to see both our Buy and Sell Option Premiums go down. There could come a time when the Sell Option premium is down by 70-80 percent of the initiation price.

Now for the 20 percent of the premium holding on to the Sell Position and curtailing our Profit Potential is Dysfunctional Risk.

Since the Sell-side option has done what it was supposed to do (well, most of it), we can now close (buyback) that option and keep holding on to the Buy Option trade to its fate.