Options are nothing but contracts that let an individual buy specific shares for a certain price. When it comes to options trading, being a seller has more risks than being a buyer. While the buyer has unlimited potential for profit with minimal scope for risk, the case is just the opposite of selling the options. Here are 10 points an individual who is going to trade options has to keep in mind.
An option seller or writer takes a contrarian stance rather than a natural stance. For example, if the option writer believes that the stock will not fall below a certain level, he will sell a put option. Likewise, if the option writer believes that the stock or index will not rise above a certain level, he will sell a call option.
The risk for both the seller of a put option and the seller of a call option is unlimited. If you sold a call option worth Rs.10 on a stock worth Rs.450, your maximum profit is Rs.10. However, if the stock price rises to Rs.470, your loss will be Rs.10 (470-450) – the premium received. If the option seller has sold a put option, the situation will be reversed. In either case, the losses are potentially limitless.
An option seller also faces the risk of options assignment. This risk exists only in the case of American options, not in the case of European options. In the preceding example, if the Tata Motors 450 call with a premium of Rs.10 has increased to Rs.470, some buyers may choose to exercise this option. When an option is exercised, the liability is assigned at random to sellers by the stock exchange. If given to you, you will incur a net loss of Rs.10 on your position.
As a result, it is always advisable for option sellers to trade with strict stop losses. Whether you sold a call option or a put option, it is always a good idea to keep stop losses in place to protect your capital. The stop loss can be set concerning the stock’s market price or the option’s price.
Remember that when you sell options, you must pay margins just like a futures position. So, if you sell a call option, the initial margin will be calculated in the same way that the initial margin for futures is calculated. This margin is, of course, adjusted for the premium receivable. Furthermore, the option seller will be obligated to pay the MTM margins and any exceptional volatility margins that may be imposed from time to time based on market conditions. These expenses must be accounted for when selling options.
Selling options is most effective when the stock or market is showing a clear trend. For example, if RIL has a consistent bullish trend, traders can profit by consistently selling options with higher strike prices. When the direction of the stock price movement is reasonably straightforward, it is possible to improve your yield on selling options by churning your money more frequently.
It is a trade-off for every option seller to choose between an in-the-money option and an out-of-the-money option. An ITM option can provide you with higher premiums, but it also carries a higher risk. On the other hand, the OTM option has a lower risk and a lower premium potential. As an option seller, you must choose your strike price wisely.
Time value works in the option seller’s favor. When you sell an option, the premium depletes over time, allowing the seller to exit the position at a profit by repurchasing it at a lower price. Thus, the option seller’s relationship with time is opposed to that of an option buyer, for whom time works against him.
Using covered calls to sell options is a highly effective cost-cutting strategy. Let’s take a look at two examples. What would you do if you bought SBI in the cash market for Rs.350, and it has since dropped to Rs.300? Assume you are convinced that the stock will reach Rs.450 in the next year due to improved profit performance. Even if you keep the stock, you can continue to sell higher call options. If the options expire worthless, the premium earned will be used to offset the cost of holding SBI. On the other hand, if the stock falls sharply in the worst-case scenario, you’ll still have your long equity position as a hedge. Second, in option spreads, selling options can significantly reduce the cost of purchasing options.
Finally, it is critical to remember that globally, 80-90 percent of options expire worthless. That is, as a seller of options, you have a much better chance of profiting than a buyer of an option. As a result, large proprietary traders and institutions are typically option sellers. Because of the skewed risk-return structure, retail investors must be more cautious when selling options.
Despite the risks being unlimited when selling the options, you also get a great incentive for taking risks in the form of earning a premium. With that all being said, having a brokerage firm like Tradepluswill do a great deal of help for you and mitigate the risks involved.