It does not matter whether you buy or sell an option based on your view. The real challenge starts now. You must not only track the performance of the option but also the various factors that could have a bearing on the option value. In addition, even if the option position is closed, you need to track how it impacted your overall trading performance. The question you need to answer is whether the particular position added to your trading profits overall or depleted your average returns. Let us look at 13 such factors (or shall we call it a baker’s dozen) that you must track regarding your options position. Here we go.
- TRACK THE IMPLIED VOLATILITY (IV) OF YOUR OPTIONS POSITION
What do we understand by implied volatility or IV here? It is the volatility that is implied in the price. The market sets a price for each option based on a number of factors like stock price, volatility, time to expiry, interest rates etc. In IV, you basically use the option price as the correct value and see what kind of volatility is implied in the option price.
Typically, option IVs make sense if you look at it over a period of time. If IVs are going up, it means the risk is going up and hence the volatility is going up. This is positive if you are an option buyer. If IVs are going down, it means the risk is going down and so the volatility is also going down. This situation is positive for the option seller. However, you cannot look at this in isolation. The best way to take call on whether option IVs are higher or lower is to compare with historic IVs. Normally, if the current IV is substantially higher than in historic IV then you sell the option and if it is substantially lower than the historic IV then you buy the option. This is a basic rule that you can follow.
- TRACKING THE IMPACT OF TIME TO EXPIRY
Why is time to expiry important? Let us say you have bought an option then the price of the option loses value with every passing day. That is an advantage for the option seller. For an option buyer, this time to expiry is important as beyond a point the premiums start falling very rapidly. At that point, the option buyer has to decide whether to hold or trigger stop loss. It is also a decision point for the option seller. If the option prices are falling rapidly, then you don’t need to wait till expiry but you can book profits earlier and release margins.
- STOCK PRICE OF THE UNDERLYING
Whether you hold a put option or a call option or whether you have sold a call or put, the most important thing you must track is the price of the underlying stock or index. For example, if Reliance price is Rs.2050 and you are holding a 2100 call option and if the price suddenly moves to Rs.2090, then it will make a big difference to your option price. The reverse to the option seller also. Typically call options gain when prices go up and put options gain when prices go down. This is a positive cue if you hold the options. For the option seller, this will be a warning to take alternate action.
- TRACKING THE SHIFTS IN OPEN INTEREST
Open Interest is the number of lots of a contract that are pending to be closed out. For example, each strike for each contract month will have a different level of open interest. The first thing you need to note is if the OI in the strike you are holding is rising or depleting fast. Low OI is not a good sign as it can hinder your exit from the option or it may come at a much higher price.
The other thing to track is how the OI accumulation is trend. For example, looking at OI and price of the underlying, you can make out whether the rise in OI is due to long build-up or due to short build-up. Similarly, you can also figure out whether there is long unwinding or short covering in the contract if you find that OI is reducing.
- TRACK VOLUME SPIKES IN STRIKES
OI is an indication of where the accumulation is happening and what kind of accumulation is happening in options. However, volumes will tell you if there is enough trading interest in a particular strike. This is important from the point of view of liquidity and also from the perspective of which strikes are seeing sudden action. For example, if you are holding a call option on SBI and you suddenly find that foreign investors are buying heavily into deep OTM puts, then it is something to take notice. There is something negative in the stock you do not know. Either you can terminate your call option position or even go ahead and shift to a put option to hedge your risk.
- KEEP A WATCH ON NEWS FLOWS ON THE UNDERLYING
This is fairly straight forward. If you are holding a call option or put option on Infosys, you are interested in major news that is price sensitive. For example, you would keep a tab on the quarterly numbers, dividends paid out, any buyback of shares proposed, major order in the $100 million + segment etc. You must also keep a watch on very sensitive data points like whether the bench is increasing or reducing and whether the operating margins are up or down. These are sentimental factors that can have a huge bearing on the price of the call or put option based on which direction the price move is expected.
- CORPORATE ACTIONS ON THE UNDERLYING
Corporate actions are announcements that have an impact on the price of the stock. Some corporate actions will also have an impact on the strike price of the option as we shall see later. Corporate actions include benefits of having shares like dividends, rights, stock splits, bonus issues etc. You may argue that as an option holder you don’t get any of these, but that is not material. For example, when a company declares a dividend, it impacts prices negatively and have an impact on option values. Secondly, if the rupee dividend declared is more than 10% of the stock price, then it is considered an extraordinary dividend and the strike prices are automatically adjusted accordingly.
Similarly, when a company does a stock split, as Eicher did, it brings high priced stocks into a more affordable range. This spurs interest in the stock and leads to a spike in prices and thus impacts options prices too. Another example is Reliance Industries which gained substantial value after the rights issue was announced last year.
| Till this point we have seen 7 factors that every options needs to track and we take a small detour here. I call it a detour because the first 7 factors that we saw were factors that were related to the stock or some external factor impacting the stock price. The next 6 factors will be unique to you. These are based more on your trading strategy and trading practices as well as your trading performance. |
- P&L BY TRADE, DAY, WEEK, MONTH, YTD
Do you track your profits on a daily basis? In the old days, the Marwari businessmen used to call it the Partha system. Under this system, the head office keeps a tab on profits and cash flows on a daily basis. Let me tell you why this is important for an options trader. For example, by looking at your profits on a frequent basis, you not only realize whether you are earning or living out of capital, but also give you a hint of where you are going wrong.
When you look at the P&L, don’t just look at the trade profit or loss. Look at the net profit / loss after considering the brokerage and other statutory costs. These add up quite a bit to the cost of your options trade. This will tell you whether you are not waiting long enough or you are perhaps waiting too long to trigger your stop loss. Tracking profits on a daily basis also gives an idea if you have enough money to pay margins on fresh positions.
- YOUR RISK REWARD IN A TRADE AND OVERALL
What do we understand by the risk-reward in an options trade? For example, when you by an option, there is a premium cost and there is a potential profit that you expect. If you are paying a premium cost of Rs.5 and you sell the option at Rs.7, you are probably still making profits but not as much profits you should make for the risk you have taken on.
The situation is different when you sell options. Here your returns are limited to the premiums received. Hence you need to set your stop loss in the trade in such a way that you have a return to risk ratio of at least 2.5:1 or 3:1. If you are setting your targets lower than that, then you are not getting paid enough for the risk you are taking. That is only evident if you continuously track the risk-reward ration on a per trade and also on periodic basis.
- TRACKING YOUR WIN PERCENTAGE AND PROFITS ON WINNING TRADES
This looks fairly straightforward. If you put 10 trades and make profits in 7 and losses in 3 then your win percentage is 70%. There is a catch here. You ask the best of traders in the options market and they would tell you that it does not make much of a difference whether you get 60% of your calls right or whether you get 80% of your trades right. What really mattes is what you do when you are right and what you do when you are wrong.
Let us say you trigger stop losses at 3% and book profits on your winning trades at 2-3%. In this case, irrespective of whether your win percentage is 50% or 65%. You would still end up making losses. The need of the hour is to hold your winning positions long enough and cut your losing positions quick enough. If you can manage that, then even at 60% success rate, you can make a lot of profits. That is why you should also measure returns percentage when you gain and loss percentage when you lose money.
- TRACK THE AVERAGE GAINS / LOSSES OF TYPES OF TRADES MADE
Why is this measure so important? After all, don’t we cover this when we look at profits per day and per trade. The focus is slightly different here. You need to use you trades to give cues on strategy. For example, what has been you return when you bought deep ITM calls? Did you made money on stocks with deep OTM calls? What is your success rate from stock options versus Nifty options? These will give you ideas of where you are making profits and what types of calls you are typically getting right. You should also do a typical analysis of loss making trades.
- TRACK THE NUMBER OF TRADES AND COMMISSIONS
Your profit is one side of the story and the other side is how many trades you had to put to get these results. Check the trend on a monthly basis. If your trades this month are 10% above last month, it is ok. However, if it is 80% more than last month, you are perhaps trying too hard and churning too much without commensurate results. Trades have a cost and more the trades more the cost.
Another important point to track is the commissions and statutory costs. These are part and parcel of every trade. However, if the broker and the government are earning as much as you then you probably have got your strategy all wrong. You have to earn substantially more than what the broker earns otherwise the whole purpose of trading in options gets defeated since you are the one who is taking the capital risk.
- OUTCOME ANALYSIS OF TRADE JOURNAL
Our last item on the tracking list is a slightly complex item. During an average day say you put in 5-6 trades. That is not too much to remember. At the end of the day, you must put down your notes on a trading journal justifying why you took the position, what went right, what went wrong and how you could have done it better. This can become a huge rallying point for you to improve your performance in the future.
Over time, this trade journal builds into a complete trading rule book for you. Of course, the condition for this to be successful is that you need to be absolutely honest and transparent when filling the daily trade journal. The rest will follow.
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