Starting your stock market journey with Options Buying is a deadly mistake. Here's what you are not seeing.
Explained with simple math.
The #1 question that I have got from our viewers and readers across YouTube and Substack over the years is - “How to make money doing Options Buying?”
Well, many of the newcomers to the market are increasingly starting with Options Buying these days due to the requirement of low capital and increased leverage.
Options are called Leveraged instruments because they allow participants to control a larger position in the underlying asset (such as stocks) with a smaller amount of capital. Today, using just ₹13,000 worth of Stock Options of Infosys you can control almost ₹6.5 Lac worth of shares. That gives people a chance to make a big profit with just ₹15000. That is why many are into Options Buying.
When designing systems and strategies, it's crucial to understand Leverage. It is simple math that is often overlooked especially by Options Buyers.
In this article, we will explore answers to the following questions.
Should you take leverage to buy or sell stocks?
Should you trade Stock Options?
Let us start with an activity.
I will present to you 2 different strategies. Please help me pick one of them.
Strategy 1: I start with Rs 1,00,000 (₹1 Lac) and I gain 1.2% on the first trade and lose 1% on the next trade. It goes on till I take 100 trades. That is +1.2%, -1%, +1.2%, -1% and so on 100 times.
Strategy 2: I start with Rs 1,00,000 and I gain 24% on the first trade and lose 20% on the next trade. It goes on for 100 trades. That is +24%, -20%, +24%, -20% and so on 100 times.
Which strategy should I pick to get better results? Try to answer intuitively.
Okay now that you have answered, let me tell you more about the 2 strategies.
The return and risk profile of Strategy 2 is nothing but 20 times that of Strategy 1.
1.2% x 20 = 24%
-1% x 20 = -20%
Strategy 2 is a 20X leveraged version of Strategy 1.
The graph below shows the progression of the Account Balance starting 1,00,000 over 100 continuous bets for Strategy 1.
Strategy 1, involving a 1.2% gain followed by a 1% loss per bet, results in a final balance of approximately Rs 109,846.28. This strategy demonstrates a steady increase in balance, reflecting a lower-risk approach with more consistent but modest gains.
Let us now look at the graph of Strategy 2.
Strategy 2, which is a 20X leveraged version of Strategy 1, with a 24% gain followed by a 20% loss per bet, ends with a final balance of approximately ₹ 66,924.26. Despite the potential for high returns due to the larger percentage gains, this strategy ultimately leads to a loss. If you continue it, you are going to wipe your capital soon.
Strategy 1, despite having a lower reward percentage is the better one. The Leveraged Strategy 2 is a loss-making strategy.
It highlights the contrast between a low-risk, lower-reward strategy and a high-risk, high-reward strategy that, in this case, results in a net loss. It is vital to balance risk and reward while forming strategies and systems, especially when considering the use of leverage.
In the above example, we saw that a 20X leverage is leading to negative returns and is likely to wipe off capital.
Do you know what is the leverage you get through Stock Options?
Let us calculate.
1 share of Infosys is trading at around ₹1616. A near-the-money Call Option is available at ₹33 with about 23 days left for expiry. One lot of Call option of Infosys consists of 400 shares. So if you buy 1 lot of Infosys Call Option you are going to spend 400 * 33.5 = 13400. In effect, you are taking control of 400 shares of Infosys. If you had to buy the same quantity of shares in cash you would have had to spend 400 * 1616.45 = 6,46,580. So what is the leverage you got?
646580 / 13400 = 48X Leverage
In the case of 20X leverage itself, the chances of making money go down. When you are trading an instrument with 48X Leverage, you are likely to wipe your capital soon.
I am not saying that it is impossible to make money doing options buying. But, it is tough for beginners. Winning Options Buying systems involve tighter risk controls, a better understanding of leverage, patience to reap big rewards and extended periods of drawdown. Psychologically very difficult to execute.
What amount of leverage is good?
I simulated Strategy 1 with a 10X leverage. That is a 12% gain followed by a 10% loss repeated 100 times. Here are the results - The account balance exhibits a consistent upward trend despite the fluctuations, culminating in a final balance of approximately ₹148,945.23 after 100 bets.
Somewhere around 5X-10X leverage turns out good for strategies with various risk-reward profiles and win rates. But you need to know how and when to use it. Completely not advisable for beginners. I would even say it is not necessary for most of us.
What the Greats had to say on Leverage
Warren Buffett: "Leverage is the only way a smart guy can go broke. It just takes some time."
Peter Lynch: "You can have all the growth you want if you use leverage. It can cut both ways."
George Soros: "When you deal with a complex system, you have to use a certain amount of leverage to make it work. But then you must always be aware of the amount of leverage you are using and you have to be prepared for a situation where you have to decrease the leverage, because if the system doesn't actually behave according to your expectations, you have to cut back."
John Templeton: "Leverage magnifies gains and losses, but losses have a habit of coming first."
Charlie Munger: "Generally speaking, it's a mistake to use leverage. Lots of people get very rich by using leverage, but some people die by it."
Key Lesson
A profitable strategy magnified by Leverage may not continue to be profitable. Avoid Options Buying when you start your journey. Do not take leverage or excessive margin to buy stocks. Amplifying your return profile through leverage is dangerous for your capital.
I use Options Buying only to protect my portfolio and do not use it to generate alpha. That is, in simple words, I do not rely on Options Buying alone to make profits.
We have discussed one key idea in this post - Leverage. There is another key idea that we can weave around the example we discussed. I will keep it for another post.
Great Explanation guru. Have a nice day.