10 Points to Remember When Selling Options

Ok, just as an option has a buyer, it also has a seller. Is that not what any market is all about? Unlike the option buyer who has unlimited profit potential and limited risk, the option seller is in a converse situation. An option seller has unlimited loss potential but his profits are limited to the premium earned on the option. Here are 10 key points to remember when selling options…

Key points to remember when selling options…

• An option seller or option writer takes a contrary view rather than a direct view. For example, if the option seller believes that the stock will not go below a certain level then the option writer will sell a put option. Similarly, if the option writer believes that the stock or index will not go above a certain level then he will sell a call option.

• The seller of a put option and the seller of a call option have unlimited risk. Let us understand this risk better. If you have sold a Tata Motors 450 call option at Rs.10, then your maximum profit is Rs.10. But if the stock price goes up to Rs.470, then your loss will be Rs.10 {(470-450) – 10 premium received}. The reverse situation will work in case the option seller has sold a put option. Either ways the losses can be unlimited.

• An options seller also runs the risk of assignment of option. This risk arises in case of American options and not in case of European options. In the above case, if the Tata Motors 450 call with premium of Rs.10 has gone up to Rs.470, then it is possible some buyer may choose to exercise this option. When an option is exercised the stock exchange will randomly assign the liability to sellers. If it gets assigned to you then you will have to bear the net loss of Rs.10 on your position.

• Hence it is always advisable for option sellers to trade necessarily 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. The stop loss can be set with reference to the market price of the stock or the price of the option.

• Remember, when you sell options, you are liable to pay margins exactly like a futures position. So if you sell a call option then there is an initial margin that will be calculated in the same way as the initial margin is calculated for futures. Of course, this margin gets adjusted for the premium receivable. Additionally, the seller of the option will also be liable to pay the MTM margins as well as any special volatility margins from time to time based on the market conditions. These costs need to be factored in when you sell options.

• Selling options works best when the stock or the market is exhibiting a clear trend. For example, if RIL is exhibiting a consistent bullish trend, then traders can make profits by consistently selling put options of higher strikes. By churning your money more often it is possible to improve your yield on selling options when the direction of the stock price movement is fairly clear.

• For every option seller it is a trade-off between an in-the-money option and an out-of-the-money option. An ITM option can give you higher premiums but also comes with higher risk. The OTM option, on the other hand, comes with much lower risk but also with much lower premium potential. As an option seller you need to take your strike decision judiciously.

• For the option seller time value works in his favour. When you have sold an option, premium will keep depleting with time giving the seller an opportunity to exit the position at a profit by buying it back at lower levels. Thus the option seller’s relationship with time is exactly in contrast to an option buyer, where the time works against him.

• Selling options are extremely effective as a cost reduction strategy by using covered calls. Let us look at two such instances. If you had bought SBI in the cash market at Rs.350 and it is down to Rs.300, what do you do? Let us say, you are convinced that over the next one year the stock will touch Rs.450 due to improved profit performance. Even as you hold the stock, you can keep selling higher call options. If the options expire worthless, then the premium earned will reduce your cost of holding SBI. On the other hand, if in a worst case scenario the stock shoots up sharply, then you anyways have your long equity position as a hedge. Secondly, in case of option spreads, selling options have an important role to play in reducing the cost of buying options.

• Lastly, it is very important to remember that globally 80-90% of the options expire worthless. That means, as a seller of options you stand a much higher chance of making profits than a buyer of an option. That is why normally it is large proprietary traders and institutions who are options sellers. Retail investors have to be a little more cautious while selling options considering its skewed risk-return structure.

As a retail investor, the opportunity to sell options and earn premium is always open to you. But remember that the risks are unlimited when you sell options. But if you are stuck in a position, then selling options can give you a unique way of helping yourself. That is something retail investors can seriously consider!