Conserving capital in options trading

There has been discernible investor interest in options trading in recent times. One reason for the rising interest is the volatility in the stock market; higher volatility makes options more valuable. The problem, however, is that most options expire worthless, leading to loss in capital. How then should investor gainfully use options trading in a portfolio framework?

This article explains the risks associated with options trading. It then discusses why investors should define risk budgets to contain such risks. It then shows how such budgets along with risk management rules help conserve investment capital.

Options carry asymmetric payoffs. The maximum loss for a call option buyer is the premium paid; the maximum profit is unlimited. For put buyers, the maximum loss is the premium paid; the maximum profit is high.

The problem, however, is that options are wasting assets. That is, they have finite life and rapidly lose value if the underlying does not move in the required direction.

Suppose an investor buys the Nifty 4,900 call option on February 12 when the underlying index is at 4,830. The option at 25 per cent volatility will be worth Rs 64. If the underlying does not move for a week, the option will decline to Rs 39. And if the underlying instead declines to 4,750 after a week, the option would be worth only Rs 18. The option rapidly loses value because of time decay; with each passing day, the option has less time to generate gains before expiry.

The option also loses value due to volatility; decline in volatility leads to fall in option value. If the Nifty index stays at 4,830 for a week but volatility declines to 15 per cent, the Nifty 4,900 call will fall to Rs 3.

Time decay and volatility factors explain why most options expire worthless every month.

The strategy then should be to conserve capital. Otherwise, investors would exhaust investment capital every month with each expiring option.

Risk budget

It is, hence, important to define a risk budget. That is, the investor should define the investment capital allocated for options trading. And then frame risk management rules to prevent losses due to time decay and volatility factors.

Risk budget, for instance, can be allocating 5 per cent of the total portfolio to the options market. Suppose the total investment portfolio is Rs 25 lakh. The allocation to options trading would then be Rs 1.25 lakh.

Just allocating risk capital does not help. An investor buying option contracts will lose sizable capital in several months if options she buys expire worthless. That is why the two per cent risk management rule is important. This rule requires that the investor should not expose more than 2 per cent of the options risk capital to each trade.

Suppose an investor buys one contract of the 4,900 call option for Rs 64 for a total outlay of Rs 3,200 (Rs 64 times 50). Two per cent of the options risk budget of Rs 1.25 lakh is Rs 2,500. The investor, therefore, cannot risk more than Rs 2,500 in this trade. Given the contract size of 50, this translates into a maximum loss of Rs 50 per option. So, the investor has to close the position if the 4,900 call declines to Rs 14 (Rs 64 less Rs 50). The next trade will carry lower risk because the risk capital will be Rs 1.25 lakh less the loss of the previous trade. This rule forces the investor to engage in only one trade at a time.

Conclusion

Options, because of asymmetric payoff, fit well within the satellite portfolio in a core-satellite framework. Time decay and volatility factors, however, lead to frequent small losses and infrequent large gains. Risk budget, therefore, helps investors stretch their investment capital despite the likelihood of options expiring worthless.