Few days in the market calendar generate as much excitement as derivative expiry. Prices swing quickly, volumes surge, and small positions can produce large gains or losses within minutes. On such mornings, many traders study GIFT Nifty for clues about the opening gap, while others keep a browser tab on Nifty Today pages throughout the session. The activity can be thrilling, yet studies by the market regulator have consistently shown that most individual participants in index options lose money. This article explains how expiry works, why it is risky, and how to approach it with respect and discipline.
How Expiry Works
Derivative contracts have an expiry date, on which the positions need to be settled and exited. The index contracts, on expiry, settle in cash, which means there is no exchange of shares. The difference between the price of a contract and its final value gets transferred to the buyer.
The options tend to lose time value exponentially as the expiry date nears, a feature called time decay. An option that is way off from the current price could potentially lose the whole value in a matter of hours, making the out-of-the-money option buyers to lose their premium. Option sellers, on the other hand, make small amounts of money consistently, which could be overruled by a single big move.
Why Expiry Days are Volatile?
There are a set of factors that influence expiry day volatility. Large market participants hedge their positions, and the demand and supply pressures push the stock prices up or down, depending on what is the biggest position. Traders refer to this phenomenon as pinning. Subsequently, there is also a sudden move in the last hour, as everyone tries to book profits or cut losses.
The liquidity also fluctuates, resulting in widening bid-ask spreads, and stop-loss orders getting triggered at worse levels.
Risks for Option Buyers and Sellers
An option buyer has limited losses as compared to the unlimited gains potential; however, he only gains if the option is in money on expiry. In a lot of cases, the directional bias has been right, but the timing has been wrong, leading to small losses. With the small losses adding up, it can really drain the trading account in a short time.
An option seller loses the premium in case of expiry, and in case of adverse big moves, the losses can be way higher than the usual earning from selling options. The risk is exacerbated due to large margins needed to short options, and gaps on expiry can lead to immediate margin shortfall, resulting in closure of positions at big losses. Additionally, both the seller and the buyer have to factor in brokerage and exchange related charges, and taxes. Derivative trading profits are considered as business income, and hence taxed accordingly. A lot of times people tend to forget the business income tax for the unrealized gains. It is always better to consult a chartered accountant for such queries. To summarize, both option buyers and sellers need to take into account a lot more risk factors apart from directional risk.
A Pragmatic Approach For Derivative Trading
If you are really interested to trade derivatives, always start with a small size. It is always better to learn the game as you go, and keep the first year as a learning year. Do not ever risk more than 1 or 2 % of the total trading account balance, and never go naked (positions without hedging) on any trade. It is always better to stick to directional bias trades, where potential losses are known upfront.
Never ever try to reverse a losing trade by risking more in the next trade, this is the most common mistake made by derivative traders, and is called revenge trading. The best way to avoid such scenarios is to set up a stop loss for the day, and if it gets hit, stay away for the day. Similarly, do not use money that is required for the monthly household expenses. Do not take advice from random people on the internet, as they might just be giving their own trading signals, without disclosing their position.
It is better to avoid trading near expiry as well. A lot of experienced traders stay away from expiry trading as well as the risks involved are way too high. There is nothing called a free lunch, and when you take up the risk on expiry, you tend to lose more than you earn. Sometimes, it is better to miss out on the chance, rather than risking the account.
A different perspective
Derivative products were designed for hedging purposes and not for speculation. If a person has a huge portfolio, it is perfectly fine to hedge it using options. However, a regular income guy should not take up speculation trades just to make some extra money.
If you find yourself obsessing over the trades, losing sleep over the profits and losses, and even thinking about revenge trading after a loss, it is best to stay away for some time. It takes years for an average person to build wealth through systematic investing in equities. Derivative trading and its associated risks are for those who love to take up risks.
