All About Options

RISKS IN OPTIONS BUYING AND RISKS IN SELLING…

An option is a contract where one person (option seller) gives another person the right to buy or sell a stock or index (option buyer) at a fixed price (strike price) at a fixed date (expiry date). These options are traded in the market. At any point of time these options can bought and sold like a stock. Premium on the option is the price of the right. It is this price that gets traded and you see on your screen.

What do we understand by risk in options?

You may wonder; why is buying options risky? My maximum loss is limited to the option premium. But then loss is never absolute but relative. Let us say you buy 3 options as under.

Underlying Asset	Option Strike Price	Option Expiry	Option Price (premium)
Reliance Industries	Rs.2100	25-Feb-2021	Rs.85 (250 shares)
State Bank of India	Rs.310	25-Feb-2021	Rs.23 (3000 shares)
Infosys	Rs.1450	25-Feb-2021	Rs.75 (600 shares)
Nifty	Rs.15,000	25-Feb-2021	Rs.140 (75 shares)
		Total Premium Paid	Rs.145,750

 

Options cannot be bought in single shares but in minimum lots. If you bought the above four options, your cost for 1 lot of the four contracts would be Rs.145,750. If these options expire worthless, you lose Rs.145,750. We will ignore brokerage and taxes to keep it simple.

Now, if you have a trading capital of Rs.10,00,000, then you lost 14.5% of your capital. Now, that looks like a big loss. That is what risk in options is all about. It looks safe in absolute terms but in relative terms the losses can build up. Let us now understand the risks to an option buyer and seller; but first a quick comparison.

Comparing Option Buyer with an Option Seller

The table below captures the option buyer and the option seller on different parameters.

Particulars	Option Buyer	Options Seller
What do they do	Buy a right	Sell a right
What is the risk	Risk is premium paid	Risk is unlimited
What do they gain	Profits can be unlimited	Maximum profit is premium
What is option premium	Premium is max cost	Premium is max return
Daily margins	Only premium is paid	Margins just like futures
Call option view	Price will go up sharply	Price will not cross a limit
Put Option buyer	Price to go down sharply	Price will not fall below a limit
Success ratio	15-20%	80-85%
Who buys options	Normally individuals	Institutions, Big traders

 

To summarize; the option buyer has limited risk and potential for unlimited profits. The option seller has limited returns and unlimited risk. Here are 4 key option risks and how they impact option buyers and option sellers. For simplicity, we stick to call options.

Risk 1 – Risk of adverse price movement

Adverse price movements are obviously. You expect the price to go up and the price goes down. If you have bought a call option on Reliance, then you want the price of the stock to go up so that the call option becomes more valuable. For example, if you bought Reliance 2100 call option for Feb-21 at Rs.35, then you would want the price of RIL to go as much above Rs.2135 as possible. RIL price staying flat or going down means losses.

What about the seller? Let us look at the person who sold this 2100 Reliance call option. The seller would prefer that the price of Reliance remains below Rs.2100 so that he can pocket the entire premium of Rs.35. Real risk for option seller starts if RIL goes above Rs.2135. After that, every rupee rise is a loss for the seller.

Risk 2 – Risk of option liquidity

This risk is similar for option buyers and sellers. Neither intends to hold the option till maturity. They would prefer to exit when they get a good favourable price. But what do they do when liquidity is very tight. That is why; first asses liquidity in terms of volumes and open interest.

Contract	Strike Price	Premium	Volumes	Open Interest
Reliance Jan Call	Rs.2100	Rs.7.85	12,412 lots	38.85 lakh lots
Pidilite Feb Call	Rs.2000	Rs.2.40	0 lots	10 lots

Data Source: NSE

Just look at volumes and open interest. Reliance call option has huge volumes and option interest. Pidilite contract has neither volumes nor open interest. Trading in illiquid options is risky for buyers and sellers of options. Here is what you must know. Firstly, non-frontline stock options are not very liquid and can be risky. Secondly, near-month options are more liquid than mid-month and far-month options. Lastly, as strikes diverge from market price, liquidity reduces sharply. Buyers and sellers of options must keep this risk in mind.

Risk 3 – Risk of option bid-ask price spreads

This is an offshoot of liquidity and spreads also affect the option buyer and the option seller in the same way. Bid-ask spread is the gap between the bid price and the ask price. Check the table below.

Data Source: NSE

The above illustration refers to the 2100 Jan call option of Reliance Industries. You can clearly see how the bid-ask spreads widen as you go to longer expiries. That enhances risk for buyers and sellers of options.

Risk 4 – Risk of volatility in the market

The most important aspect of options is volatility. You call it standard deviation in markets but simply put, if the price wanders too much up and down, then it is volatile. For option buyers and for option sellers volatility is the biggest source of return and also of risk.

For an option buyer, more volatility means more price movement and more scope for profits. If stock becomes less volatile, it is a risk for the option buyer. Even if the stock price remains constant, option price will keep falling. Then, option buyers trigger stop losses.

For an option seller, more volatility means more price movement and so more risk. It means price can move against them. But, if stock becomes less volatile, it is a profit for the option seller as there is a chance of taking the entire premium. When volatility spikes, the risk for the option seller is that even if the stock price remains constant, the option price will move up adding to losses. That is when option sellers trigger stop losses.

References:

Options as a Strategic Investment by Lawrence McMillan: Click here to buy now