PDF Summary:Option​s Trading Handbook, by Mahesh Chander Kaushik

Trading options opens up opportunities to create wealth through strategic speculation—but also exposes traders to significant risks. In Options Trading Handbook, Mahesh Chander Kaushik provides a comprehensive guide to navigating this complex market.

First, learn the fundamental mechanics of options and the factors that shape their pricing. Then, uncover common trading hazards and low-risk strategies such as ratio spreads and covered calls. Kaushik also reveals his unique "money tree" system for building an options portfolio through systematic investments in exchange-traded funds. Throughout, he emphasizes the psychological discipline and long-term approach traders need to control emotions and implement a structured, rule-based trading plan.

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• Some successful traders may focus more on the macroeconomic indicators or company-specific news that can affect an underlying asset's price rather than the complex mathematical models used to determine option prices.
• Some risk mitigation methods, like hedging, can be complex and difficult to execute properly, potentially introducing new risks instead of reducing them.
• Market conditions in a simulation can be vastly different from live markets, where liquidity constraints, slippage, and order execution delays can affect outcomes.
• Over-reliance on practice methods could lead to overconfidence if the simulated success does not translate into real-world scenarios, potentially causing a trader to underestimate the risks when they start trading with real funds.

Approaches to participating in options trading that involve minimal risk.

The part of the book focuses on methods for option trading that prioritize risk reduction, managing possible losses, and targeting consistent profits. Kaushik emphasizes the need for careful implementation and thorough analysis of these strategies, which can result in a synchronized approach to options trading, minimizing potential financial losses while offering opportunities to capitalize on favorable movements in the market.

The transaction process, which consists of four stages, is applicable to transactions involving both the NIFTY and the Bank NIFTY indices.

The approach focuses on quickly capturing profits through buying and selling options when they exceed the previous day's recorded peak and trough values.

The book introduces the 4-stroke method as a targeted approach for commencing intraday trades within the NIFTY and Bank NIFTY segments. This strategy focuses on identifying opportunities to leverage price fluctuations that occur within a brief period by detecting moments when prices exceed the previous day's peak or trough. The fundamental approach entails swiftly entering trades as soon as the price surpasses the previous day's peak or dips below its trough, aiming to quickly capture profits. The approach is ideal for individuals who engage regularly in market activities and possess the ability to closely track fluctuations during active trading hours.

Kaushik illustrates the four-phase method using a scenario in which the NIFTY future concludes its trading day at 10,873.30. For the upcoming weekly expiration, the investor's objective is to identify the nearest call and put options that are in the money. The strike price of the call option is fixed at 10850, and the put option, deemed to be in the money, has a strike price that is slightly higher at 10900. The trader would record the highest and lowest values of the premiums for both call and put options, using the range from the prior day as a reference. When the trading value of the 10850 call option exceeds the previous day's highest level, the trader should commence buying with the aim of earning a ten-rupee profit. If the initial price is beneath the previous day's lowest, the trader should proceed with the liquidation of the call option to secure a profit of ten rupees. This method is equally applicable to options that are sold with the expectation that the stock price will decline. This approach necessitates swift decision-making and a disciplined methodology for establishing objectives and executing loss prevention measures.

Other Perspectives

• The strategy does not seem to incorporate fundamental analysis, which can be crucial for understanding the broader market context and the intrinsic value of options.
• The 4-stroke method, while targeted, may not account for the complexity and unpredictability of market forces that can affect intraday trades, making it potentially oversimplified for the dynamic nature of the NIFTY and Bank NIFTY segments.
• Price fluctuations can be caused by a variety of factors that are not predictable by simply looking at the previous day's price extremes.
• The approach may not be suitable for individuals who have other full-time commitments, as it requires constant market monitoring which could be impractical for those unable to dedicate significant time to trading.
• This approach may lead to a narrow focus on immediate expiration options, potentially causing an investor to miss longer-term trends or opportunities that could be more profitable.
• Relying solely on the previous day's range does not consider the context of why those levels were reached, such as whether they were driven by exceptional events that are unlikely to repeat.
• The approach could lead to overtrading, as it encourages frequent transactions based on a single price point criterion.
• The rule for liquidation based on the previous day's low does not take into account the overall trend of the market, which could lead to premature selling in a bullish trend.
• Selling options with the expectation that the stock price will decline may not always mirror the dynamics of buying options, as the risk profiles are inherently different. While buying options limits the loss to the premium paid, selling options can lead to unlimited losses, which makes the strategy not "equally applicable" in terms of risk.
• The need for swift decision-making could exclude traders who are more analytical and methodical in their approach, potentially alienating a segment of the market that prefers thorough analysis over speed.

Investigating the strategies referred to as ratio spreads.

The call ratio spread and put ratio spread are strategies that employ a calculated combination of purchasing and selling options to balance risk with the pursuit of possible profits.

Kaushik delves into a strategy known as the ratio spread, where option trades are executed in a specific proportion, commonly at a one-to-two ratio. The aim is to limit potential losses while capitalizing on specific market movements. An investor employs the call ratio spread strategy by purchasing a call option with an intrinsic value and concurrently offloading two call options at a greater strike price than the current market value, with the intention that the revenue from the options sold will surpass the expense of the option acquired. Kaushik recommends that traders finalize their trades by the end of the trading day to capitalize on the reduced time value characteristic of options, thereby benefiting from the fluctuations in their prices. This strategy is well-suited to a market that does not experience significant upward or downward trends but rather shows slight fluctuations in value.

Mahesh Chander Kaushik provides a practical example using figures from options on the NIFTY index, highlighting that during the period in question, the NIFTY was valued at 9105.30 for trading purposes. The investor chooses to buy a call option with a strike price under the current market value at 9100 and at the same time sells a pair of call options that have a strike price set at 9400. This strategy yields a profit if NIFTY closes below 9400 on expiry, with the profit capped at the difference in premiums. Should the NIFTY index close beyond the 9400 level, there will be losses. Kaushik emphasizes the necessity of closely monitoring one's trading positions to decide whether to lock in profits or reduce holdings in response to market volatility and individual risk tolerance.

Other Perspectives

• The effectiveness of these strategies is contingent on precise market conditions; they are not universally applicable and may not perform well in all market environments.
• The strategy might not be as effective in markets that are trending strongly, as the underlying assumption is that the market will not make a significant move in either direction.
• While the ratio spread aims to limit potential losses, it can also result in unlimited losses if the market moves significantly against the position, especially with the call ratio spread if the underlying asset's price rises sharply.
• If the stock price ends up between the strike prices of the bought and sold calls, the investor may face a complex situation at expiration, where the long call may be in-the-money while the short calls are out-of-the-money, requiring careful management to avoid losses.
• Closing trades by the end of the trading day to capture the reduced time value might not always be the best strategy, as it could limit potential profits from holding the position longer if the market moves favorably.
• Markets that exhibit slight fluctuations might still present opportunities for other strategies that could potentially offer better risk-reward profiles, such as iron condors or butterflies, which could be more profitable in a range-bound market.
• The example provided is based on historical data from the NIFTY index, which may not be indicative of future performance or applicable to other indices or securities.
• The strategy does not account for transaction costs, which can eat into the profits from the premiums, especially in a scenario where multiple adjustments might be necessary.
• While monitoring trading positions is important, over-monitoring can lead to overtrading due to emotional responses to short-term market movements, which can erode profits through increased transaction costs and taxes.

Implementing a strategy that involves the sale of options known as covered calls.

Selling call options when you own the corresponding asset can provide a consistent income and reduce the risk of losses.

Kaushik advocates for a technique called covered call writing, which entails possessing the underlying asset while simultaneously selling call options linked to that asset. Investors can consistently generate revenue by accumulating premiums and at the same time reduce the risk of substantial financial losses through this approach. Kaushik suggests two tactics for covered calls: one involves selling a call option with a strike price lower than the current market price, and the other involves disposing of a call option with a strike price that is higher than the current market price. He acknowledges the comparative security offered by both methods, yet he leans towards the strategy that involves establishing positions for covered calls subsequent to acquiring the stock, as it presents a reduced risk.

Kaushik illustrates a scenario where a trader possesses a set of options equivalent to 500 Reliance shares, each priced at Rs. 1400. In implementing a covered call approach, the trader acquires the underlying asset while concurrently writing a call option with a strike price set at Rs. 1500, thereby earning an option premium of Rs. 36 per share. Should the market value of Reliance stock stay within the range of Rs. 1400 to Rs. 1500 up to the option's expiry, the seller of the option may keep the premium without being compelled to sell any shares. In the event that the stock price surpasses Rs. 1500, the call option holder has the right to buy the shares, potentially resulting in a profitable deal for the seller of the option. Kaushik emphasizes the importance of balancing the number of call options sold with the equivalent number of shares held to reduce possible losses in the event that the stock price exceeds the agreed-upon exercise price.

Practical Tips

• Create a personal finance blog or vlog documenting your journey learning about covered call writing. Share your progress, what you've learned, and the hypothetical outcomes of your strategies. This will not only reinforce your own understanding but also provide a platform for feedback from others who might offer insights or share their experiences with similar strategies.
• Create a decision-making flowchart to determine when to sell call options at lower or higher strike prices. Start by identifying factors that influence your decision, such as market volatility, your risk tolerance, and the performance of the underlying stock. Use this flowchart whenever you consider selling a call option to help you make consistent and informed decisions.
• Develop a personal checklist for stock selection criteria that align with covered call writing. This might include factors like stock volatility, dividend yield, and company fundamentals. Use this checklist when evaluating potential stock purchases to ensure they are suitable candidates for subsequent covered call positions.
• Create a simple spreadsheet to monitor real stock prices and set up alerts for when they approach your target strike price, like Rs. 1500. Use the spreadsheet to record the date, stock price, and whether it would be beneficial to exercise a call option at that price. This hands-on tracking can help you grasp the timing and potential profitability of exercising options.
• Engage in a peer discussion group focused on options trading strategies. Find or create a local or online group where you can discuss different hedging techniques, including the balance between call options sold and shares held. Sharing experiences and scenarios with peers can provide new insights and practical understanding of how to manage potential losses in various market conditions.

Building a financial portfolio using Exchange-Traded Funds and Systematic Investment Plans as core components, with an emphasis on the trading of options.

The section unveils Mahesh Chander Kaushik's unique approach to options trading, known as the "money tree" strategy. This approach utilizes Exchange Traded Funds (ETFs) and Systematic Investment Plans (SIPs) to create a consistent income flow and mitigate risk by carefully employing options backed by the assets they represent. Kaushik underscores the importance of a sustained and methodical strategy, comparing it to cultivating a tree which yields both fruit (profits) and provides shade (steady premium income).

Regularly channeling capital into a diverse collection of exchange-traded funds that mirror the performance of indices such as the NIFTY or Bank NIFTY through disciplined investment strategies.

Creating a varied portfolio of ETFs with minimal expenses lays a strong groundwork for engaging in strategies related to trading options.

Kaushik recommends consistently allocating funds to a varied array of ETFs that reflect the performance of major indices such as the NIFTY or the Bank NIFTY through systematic investment approaches. He argues that ETFs, which replicate specific market indices, naturally offer a diversified portfolio and generally come with lower costs compared to actively managed mutual funds. Investors can methodically develop a varied investment collection that reflects the wider market, similar to nurturing a plant that yields financial gains. He advises purchasing shares in NIFTY BeES. NIFTY BeES offers an opportunity to diversify one's portfolio across the top 50 companies, which are constituents of the NIFTY 50 index, while Bank BeES facilitates allocation of investments across a curated group of 12 leading banks that form part of the NIFTY Bank index.

Kaushik advises starting your investment by purchasing at least 7500 units of the selected ETF. Once this level is attained, an individual may initiate the strategy of composing covered calls, starting with a single set of options, particularly targeting the NIFTY or Bank NIFTY indices. He advises allocating a manageable weekly amount for consistent investments, like five thousand rupees. This investment strategy is akin to steadily tending to a financial garden with consistent attention.

Practical Tips

• You can automate your ETF investments by setting up a monthly bank transfer to your brokerage account. By doing this, you ensure that you consistently invest without having to remember to make the transfer each month. For example, if you get paid on the 1st of every month, you can set up an automatic transfer for the 2nd, so a portion of your salary goes directly into your investment account.
• Start a virtual stock market game with friends or family where each person builds a mock portfolio that reflects the wider market. This can be a low-risk educational tool to understand market dynamics and the importance of diversification before investing real money.
• Set up a monthly investment plan with a small, manageable amount to invest in NIFTY BeES. By automating your investments, you can take advantage of dollar-cost averaging, which involves buying a fixed dollar amount of a particular investment on a regular schedule, regardless of the share price. This strategy can help in reducing the impact of volatility on the overall purchase.
• You can diversify your investment portfolio by researching sector-specific exchange-traded funds (ETFs) that focus on different industries. By doing so, you'll spread your risk beyond the banking sector and potentially tap into growth opportunities in other parts of the economy. For example, consider ETFs that track technology, healthcare, or consumer goods sectors, and compare their performance and management fees to make informed decisions.
• Consider forming an investment club with friends or family where each member contributes a set amount of money each month. Pooling resources can make it more feasible to reach the 7500-unit goal collectively. For instance, if ten people contribute $200 each month, the club would have $2000 monthly to invest in the ETF, allowing the group to reach the target number of units more quickly than individual members might on their own.
• Partner with a friend or family member who also wants to invest regularly and establish a mutual accountability pact. Agree to check in with each other weekly to confirm you've both made your investment. This social commitment can be a powerful motivator, as you're less likely to skip a week when you know someone else is counting on you to stay on track.
• Set up monthly "weeding" alerts in your calendar to review and potentially prune underperforming assets. Just as a gardener regularly removes weeds to prevent them from choking out the plants, use these alerts as reminders to assess your portfolio and decide if any investments are no longer serving your financial goals and might need to be sold off.

Employing a technique of composing covered call contracts for investments in exchange-traded funds.

By employing strategies that include the issuance of covered calls linked to investments in exchange-traded funds, it is possible to generate income in a way that is favorable for tax purposes.

As the ETF portfolio grows to include 7,500 units, Kaushik recommends implementing a strategy that involves writing call options against the held shares. He advises starting by selecting covered call options that have a strike price that is 5% higher than the current market value of the ETF. This approach allows for the appreciation of the asset's worth while concurrently creating revenue by initiating contracts for call options.

Kaushik advises reinvesting the consistent returns generated by the investment into the ETF to boost the growth of the portfolio and increase the advantages of compound interest. The strategies are seen as an evolving asset that appreciates in value and consistently generates income, akin to a plant that, with time, produces monetary rewards.

Practical Tips

• Create a simple spreadsheet to track the performance of your covered call strategies over time. Include columns for the ETFs you've selected, the premium received from selling the calls, any capital gains or losses, and the effective tax rate on those transactions. This will help you visualize the tax advantages and assess the overall performance of your strategy.
• Create a visual growth tracker, like a chart or spreadsheet, to monitor the progress of your ETF investments and the impact of reinvested returns. By tracking the number of shares owned, dividends received, and the value of your investment over time, you can see the tangible effects of compound interest and stay motivated to continue investing consistently.
• Start a micro-investment garden by allocating a small amount of your monthly budget to purchase dividend-yielding stocks or peer-to-peer lending. Just like watering a plant, regularly invest a fixed sum into these assets to watch your financial garden grow over time. Think of each stock or loan as a seed that will eventually bear fruit in the form of passive income.

Overseeing and adjusting the growth of the financial portfolio as time progresses.

Regular adjustments to covered call strategies and the reinvestment of profits can lead to a gradual increase in the value of the investment holdings.

Maintaining the vitality and output of your financial assets requires constant vigilance and adjustment. Kaushik emphasizes the need for regular monitoring of the ETF portfolio, ensuring it remains aligned with the chosen index and risk profile. He advises regularly modifying the ETF's makeup to maintain the desired asset allocation and risk profile.

Kaushik stresses the importance of adjusting covered call positions in response to market volatility. If the ETF's value significantly exceeds the strike price of the call option, it is likely that the call option holder will choose to exercise their right to purchase the shares. In such situations, Kaushik advises selling off some of the ETF holdings to make up for the deficit, while maintaining at least 7500 units in the portfolio to continue with the strategy of writing covered options. He underscores the importance of strategically extracting value from the investment while preserving its potential for ongoing prosperity and revenue production.

Context

• Regular adjustments can help maintain diversification within the portfolio, which can reduce risk and improve the stability of returns.
• Financial regulations can change, affecting investment strategies. Staying informed about these changes is essential for maintaining compliance and optimizing investment outcomes.
• Many ETFs are designed to track a specific index, such as the S&P 500. This means they aim to replicate the performance of the index by holding the same or similar assets in the same proportions.
• Strategic adjustments to an ETF's holdings can capitalize on emerging opportunities or mitigate potential risks, enhancing the overall performance of the investment portfolio.
• The primary goal of a covered call strategy is to generate additional income from the premiums, which can be reinvested to enhance overall returns.
• Selling ETF holdings when the market value is high allows the investor to lock in profits and rebalance the portfolio. This action can help maintain the desired level of investment and risk exposure.
• Having a substantial number of units ensures better liquidity, making it easier to adjust positions in response to market changes without significantly impacting the asset's price.

The psychological and conduct-related elements that enhance one's skill in options trading.

This section of the document delves into the vital, but often overlooked, psychological and behavioral aspects unique to trading options. Kaushik emphasizes that mastery over these aspects can be as crucial as technical knowledge, as emotional discipline and a structured approach can significantly impact trading outcomes. He underscores the necessity of managing emotions, adhering to a well-defined investment plan, and fostering a patient, long-term perspective to navigate the inherent volatility of options trading successfully.

Developing emotional discipline and risk management skills

To succeed consistently in the realm of option trading, one must navigate around common psychological traps such as overconfidence and an irrational fear of losses.

Kaushik emphasizes the necessity of maintaining emotional control when trading options. He highlights the common challenges traders face in making logical decisions, such as the tendency to become overly confident after a series of successful trades and the habit of holding onto losing positions for too long. Mahesh Chander Kaushik underscores the necessity of refining risk management techniques to mitigate potential monetary losses. This involves setting realistic expectations, determining a comfortable risk tolerance level, and implementing strategies to protect capital. He recommends that traders set clear exit strategies for every trade to guarantee that their decisions to exit are grounded in predetermined conditions, thus circumventing emotionally charged choices within trading hours.

Other Perspectives

• The concept of emotional control can be too vague or subjective to serve as a practical guideline for trading without concrete methods for achieving and measuring such control.
• It's possible that some traders might actually benefit from a certain level of confidence, as it can help them to execute their strategies decisively and without undue hesitation.
• In some cases, strict adherence to risk management rules can result in missed opportunities, as the market might move favorably after a risk management rule has triggered an exit from a position.
• Risk tolerance can change over time, and what is comfortable at one point may not be appropriate later, possibly leading to complacency or inappropriate risk-taking.
• Exit strategies are based on the assumption that market conditions and personal circumstances remain constant, which is rarely the case; hence, they may need to be adjusted more frequently than anticipated, which can be a complex and time-consuming process.

Implementing a structured, rule-based approach to decision-making

Following a well-defined trading plan and maintaining discipline in executing trades can help mitigate the impact of emotions on trading outcomes

Kaushik advocates for a methodical strategy with definitive guidelines for handling options trading, which diminishes the chance of impulsive decision-making driven by emotions. He counsels investors to meticulously devise a trading strategy that specifies their financial objectives, risk appetite, favored tactics, and precise criteria for initiating and concluding trades. The approach serves as a roadmap, providing a methodical framework for making informed and consistent decisions, especially in periods of market volatility. He underscores the necessity of adhering strictly to the plan when making trades. It is crucial to consistently follow set rules, particularly when market fluctuations trigger emotional instability.

Practical Tips

• Implement a "cooling-off" period by setting a timer for a few minutes before confirming any trade. During this time, step away from your trading desk, take deep breaths, or engage in a brief physical activity like stretching. This short break allows you to reassess your decision with a clearer mind, potentially saving you from impulsive trades that don't align with your disciplined trading plan.
• Create a decision journal to track the outcomes of your choices. Start by writing down the decision you need to make, the reasons behind your choices, and the expected outcome. After a set period, review the decision and the actual outcome to evaluate the accuracy of your predictions and the quality of your decision-making process. This practice will help you identify patterns in your thinking and improve your methodical approach over time.
• Implement a monthly 'stress test' on your investment portfolio. Choose a day each month to review your investments and simulate different market scenarios, such as a sudden market drop or a prolonged downturn. Assess how your portfolio would perform in these situations and make adjustments if necessary to align with your predetermined rules, ensuring you're prepared for actual market volatility.

To succeed in the realm of options trading, cultivating patience and embracing a long-term outlook is crucial.

Grasping the concept that option trading resembles a marathon rather than a sprint helps traders maintain a long-term outlook, essential for weathering short-term market volatilities and achieving lasting success.

Kaushik underscores the importance of adopting a patient, long-term approach to trading options, recognizing that swift gains or immediate wealth accumulation is seldom the path to success. He advises those interested in the field to tackle the challenges of option trading with the persistence of a long-distance runner, highlighting the importance of unwavering commitment, toughness, and the ability to withstand temporary market fluctuations while keeping an eye on enduring goals. Kaushik underscores the necessity for continuous learning and adaptability in response to the constantly evolving market landscape. He recommends that traders stay informed about market trends, economic indicators, and new strategies to improve their approaches and adapt to changes in the market.

Practical Tips

• This regular check-in ensures you're not making impulsive decisions based on short-term market fluctuations. For instance, if you notice a particular option strategy consistently underperforms, you might decide to allocate less capital to it or seek alternative strategies that align better with the marathon mindset.
• Create a personal commitment contract that outlines your trading goals and the strategies you will stick to, even during market downturns. This contract should be reviewed weekly to reinforce your commitment and adjust strategies as necessary, fostering a habit of persistence and adaptability.
• Create a personal "Adaptability Journal" where you reflect on weekly changes in your industry and how you've responded to them. This could involve noting new trends, technologies, or shifts in consumer behavior, and then brainstorming ways to adapt your own strategies or skillset in response. Regularly reviewing this journal can help you become more proactive and less reactive to changes, enhancing your ability to navigate the evolving market.
• Engage in micro-trading experiments to test out new strategies with minimal risk. Allocate a small budget that you're comfortable with potentially losing, and use it to experiment with different trading approaches. For example, if you're interested in momentum trading, you could use your budget to buy a small number of shares in a company that has recently announced positive news and track the performance over a week.