InvestorQ : I have been buying options for some time and I understand that I can earn regular income by selling options. What are your thoughts?
sara Kunju made post

I have been buying options for some time and I understand that I can earn regular income by selling options. What are your thoughts?

3 years ago

Firstly, you are getting into a new area with higher relative risk. So be very clear that you have the capital base and the appetite to take on such a risk. 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. How exactly to go about selling options in the market?

Some important points that you must remember when selling options

Buyer takes a direct view while the seller of an option takes an indirect view. 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.

Rule 101 is that risk is unlimited for the seller of an 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.

While the assignment risk does not exist any longer, it is still useful to know what this risk is all about. 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. Now that all options are European in nature, this risk of assignment is not existent any longer.

Surprisingly, the most important thing for options sellers is to keep strict stop losses and build in risk management. 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.

Selling options attracts margin liability; both for initial VAR margins and also for MTM margins. 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.

Like in the case of option buyer, the seller has to also make a trade-off. 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.

The one think that option sellers look for is time decay or Theta. Here is what it is. 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.

The best use of option selling is not for punting in the market but to reduce cost of holding a stock. 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.

Did you know that as an option seller you have a statistical advantage over the buyer? 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.