Anatomy of a Losing Trade

Today, I lost approximately Rs.4000 in a Sun Pharma Options Trade. It is worth examining the trade, because I think it gives valuable trading lessons.

On the face of it, why am I even talking about this trade? It is only one among the hundreds that I do every month. The amount involved is trivial. Losses are the part of life of any trader. So why worry about it? Forget it, and move on, just like a bunch of other losing trades.

I think, however, that this particular trade contains valuable lessons on what not to do while trading. And therefore merits a deeper examination.

I consider myself an experienced and sucessful trader. One who has a track record of success, who is diversified across instruments, and someone with (at my risk levels) who has access to unlimited capital, and a proven capacity to bear tremendous losses. Why did I get this trade wrong?

First, the logic of the trade and the trade itself.

At a time (10 a.m on 22 Feb 2018, expiry day) when Sun Pharma was trading at 528-529 (up nearly 0.75% on a weak market day), I entered into a 530CE/540CE ratio trade in the ratio 1:3.

I got the idea for such trades from Jeff Augen’s excellent book on trading options at expiration. In this book, Augen talks about two peculiar behaviors in options on expiration day. The first is the propensity for stocks to exhibit pinning behavior (getting pinned to a strike price, and jumping discretely from one strike price to another), and the other is the dramatic collapse of IV (or a dramatic time value decay, in an Indian context, because we have no after market). Augen suggests therefore that it makes sense to enter into call ratio trades in heavily traded stocks. What he suggests is that one chooses the long strike of the call ratio where the underlying is just out of the money or just in the money. And then he suggest selling a ratio at the next higher strike, which just allows for a small net debit or credit (and which usually results also in the trade being roughly delta neutral to begin with). If the underlying falls, the both sides of the ratio expire worthless, and all you lose or gain is the small debit/credit one started with. If the underlying rises, but not too much, the long side of the ratio will expire in the money, and the short side will expire worthless, resulting in a nice gain. And if the underlying does get pinned to the higher strike, then the profits will be tremendous. Breakeven is when the underlying rises by [Strike Price Spread + Strike Price Spread/ratio], which is usually a 3.5% or so move, which is unlikely in most stocks.  So the risk:reward characteristics of the trade are excellent.

Unfortunately, I have still not been able to build conviction that stocks in India also exhibit pinning behavior. Unfortunately, I still don”t have a database of minute prices in stocks, and so I haven’t been able to backtest this (am in the process of correcting this)

In this particular Sun Pharma Trade, I purchased one Feb 530CE at 5.2 Rs, and sold 3  Feb 540 CE at 1.9 Rs. This resulted in an initial credit of Rs. 0.5 or on the lot, a credit of Rs. 550. Nice. I was a happy camper.

There was a lingering fear at the back of my mind. Sun Pharma was due for some news flow (the FDA inspection of one its plants was ongoing). The risk was positive news flow which would result in a sharp price increase.

The second problem, as I see it, was that while I entered into several similar trades on other stocks around the same time, I was entering into call ratio spreads on expiry for the first time. And I was quite personally excited to see this work.

The third issue I think was that I had a successful run at options trading for the first time in the Feb expiry, with practically no losing trades. So I was actually quite eager to retain my profits (though my options profits/losses are a  much smaller component of my overall trading position, and these losses/profits are not material).