Naked Option Buying Works
We have an example trading system backed by live results which uses only naked option buying. Now most people would frown upon such naked buying of option and advice against it. But that is like saying
- don’t drive a car because you could have an accident or
- don’t play sport because you could get injured or
- don’t eat because you will be inflicted with cancer from pesticide laden produce
There are several instruments. tools and strategies out there. Its up to us to use these according to our needs. Option buying can work depending on strategy metrics. Lets see some obvious benefits of option buying.
- Limited risk - We won’t loose more than what we have paid as premium, no matter what happens in the market.
- Unlimited profit - If market moves in our direction we will be able to ride the trend as long as it stays.
- Lower transaction cost - Much lower than futures (another instrument for riding trends)
- No leverage - Trade only with the money we have. No pledging or margin reliance. This means there is no margin shortfall penalties as well which option sellers need to be constantly aware of.
- Low capital - Since the option premium in buying is much less compared to the margins required for selling the per trade capital exposure moneywise is much lower compared to selling and even hedged selling positions.
- Simplicity - Its so easy to buy naked options in the direction of trend rather than devoting one self to all those complicated option selling strategies (which also involves buys still). When something is super simple it also becomes super easy to follow, which is a critical aspect of profitable trading.
But naked option buying does have time value degradation. As we move close to expiry day time value degrades exponentially. This however can be managed to work in our favour. If we have a system with win rate less than loosing rate then the time value degradation balances out over a period of time. The Option LTP doesn’t move 1:1 with spot. For a weekly ITM option, close to spot, the delta is around 0.5-0.6 on a Thursday (one week prior to expiry). It gradually approaches 1 as we move towards the expiry Thursday. If there is a spot movement against our position by X points we don’t loose 1:1 (unless expiry day). We loose only in proportion to delta. If there is a spot movement in our direction we don’t make 1:1 profit (unless expiry day). But the profit is in proportion to delta. For a trend following indicator like TrendShikari NTS the accuracy is around 47% only. So if we take 100 trades we loose time value on 47 trades and gain because of time value effect on 53 trades. This means the time value effect is more or less negated by the accuracy factor over a fair number of trades. Also, if there is a big trend running for a few weeks we may consistently keep loosing some part of the immensely profitable trend to time value. But here again the capped risk of the naked option position limits and counter balance the above when there are gaps against our overnight positions. Market does have its minor gaps and major black swan days !!!
