Whether you sell index options or stock options, there are some points to remember when selling options. Options selling may look like complex as your loss is unlimited, but in reality, option sellers make money more often. Here are 10 tricks of option selling.
10 points to keep in mind when selling options
Selling options works best when the stock is exhibiting a clear trend and taking strong support or meeting stiff resistance. If Tata Motors is exhibiting consistent bullish trend, traders can enhance profits by consistently selling put options of higher strikes.
Should you sell ATM, ITM or OTM options? It is a trade-off. ITM option gives higher premiums but also comes with higher risk. The OTM option comes with much lower risk but also with much lower premium potential. Strike this balance among strikes judiciously.
For the option seller, time value works in favour. When you sell an option, premium keeps depleting with time giving the seller an opportunity to book profits by buying it back at lower levels. Thus the option seller gains from Theta decay.
Selling options is extremely effective as a cost reduction strategy by using covered calls. Even as you hold the stock in your portfolio, you can keep selling higher call options. If the options expire worthless, then premium earned will reduce your cost of holding.
Remember, globally 80-90% of options expire worthless. As a seller of options you stand a better chance of making profits than a buyer of an option. However, you must be cautious while selling options considering its skewed risk-return structure.
An option seller/writer takes a contrary view. If the option seller believes that the stock will not go below a certain level then the option writer will sell a put option. It is more of a non-affirmative view in the markets.
Sellers of put and call options have unlimited risk. If the price movement goes against, you may end up booking huge losses. That is why; selling of options must never be done without a stop loss and ideally have an underlying position to reduce risk.
All stock options have moved into delivery and hence all options positions open in the last week will start to suddenly attract substantially higher margins from the beginning of the last week and you must factor this in any short option.
It is always advisable for option sellers to trade with strict stop losses. Irrespective of whether you have sold a call option or a put option, it is always advisable to keep stop losses so that your capital can be protected.
When you sell options, they attract margins in the same way as buying and selling futures. The margin call will be adjusted against premium receivable. Selling options attract upfront margins and MTM margins in the same manner as long futures and short futures.
IS IT EASY TO DECIDE WHEN TO BUY AND WHEN TO SELL OPTIONS?
This may look like an inane question, but it is an important question that most traders must answer. Take the case of the famous Barings Bank of 1995. The bank sold Nikkei strangles heavily and when the Kobe earthquake struck, the bank had to take a $1 billion write-off and the capital got wiped out. Had Nick Leeson bought the strangle strategy, Barings would still have been around and Leeson would have been richly rewarded.
What should be your call option trading strategy? How do you decide when to buy and when to sell an option?
Is the option underpriced or overpriced?
You cannot calculate the intrinsic value of an option the way you calculate for equities but you can apply Black & Scholes model. If the price of the option is above the intrinsic value then it is overpriced and needs to be sold. If the price is below the intrinsic value it is time to buy the option.
Is market volatility going to increase or reduce?
Remember, that both call and put options benefit from volatility because it makes the option valuable on the upside but your downside risk is limited anyways. To know about Call and Put option and to know the basics of Derivatives Click here. Even if the stock price remains at the same place, the value of the option can go up if volatility goes up. It is always advisable to be buying options when the volatility is likely to go up and sell options when the volatility is likely to go down.
Look for key events with disruptive potential
Like Nick Leeson and Barings, people have lost billions of dollars selling options on sub-prime, silver and gold and ended with huge losses. Quite often, we lose perspective of the disruptive potential of certain events or announcements. If you sold options ahead of cataclysmic events then your capital could get wiped out.
Is your view affirmative or defensive?
This is an interesting point. An affirmative view is when you either expect the stock to decisively go up or down. In that case you either buy a call option or a put option as the case may be. But what if you have a defensive view? For example, if you believe that Tata Steel will not go above Rs.400, it is better to sell a 410 call option on Tata Stock, than trying and buying puts.
What is time left to expiry?
Time works against the buyer of the option and in favour of the seller. In the initial days of the month time decay is stable. But as expiry date approaches, you find the time decay beginning to work more rapidly. When options start losing value rapidly, it is not a very good idea to buy options unless you really want to take a risk and bet on volatility. You are best being a seller!
Want to know more about Options trading Strategy? Read here