Buying an option entails limited downside risk in the form of option premium but unlimited upside potential if the price moves in your favour. On the other hand, when you sell options you have limited upside in terms of premium income but unlimited downside risk if the price movement is against you. However, globally over 90% of all options that are purchased expire worthless. That essentially means that option buyers make profits only in 10% of the cases whereas option sellers make profits in the balance 90% of the cases. Remember, option sellers are mainly institutions, HNIs and proprietary desks and they normally tend to be better informed and also use more sophisticated algorithmic methods of trading. While smaller traders also indulge in option selling, here are some key things to keep in mind while selling options
1. Option selling must be done with strict stop loss
When you buy options, a stop loss may not be too important unless you have purchased an ITM option paying a hefty premium. But when you sell options, your risk gets multiplied as you have no protection on the downside. For example, if you had sold put options on Infosys a day ahead of Vishal Sikka's resignation, then your leveraged position would have resulted in massive losses on the day when Infosys crashed by 10%. In such cases, a stop loss to cut your losses is inevitable. Even if you have to book a slightly higher loss than anticipated, it is better than seeing your entire capital wiped out.
2. Beware spikes in volatility in the market
When you buy an option, the volatility works in your favour. But when you sell options the volatility actually works against you. This is more acute when it comes to the Nifty since the index tends to be more vulnerable to shifts in volatility. For example, if you have sold Nifty 10,000 call option at Rs.60 and if the volatility spikes up then the option value could spike up to Rs.70 even though the spot price of Nifty may not have changed. This results in a notional loss on your option selling position. In cases of spike in volatility you must ensure that strict stop losses are adhered to.
3. Risk of assignment options
Options are either American or European. In India, till 2011 all index options were European while all stock options were American. A European option is exercisable only on the date of expiration while an American option is exercisable on any date prior to the expiry. When an option buyer chooses to exercise the option, he goes to the exchange and opts for exercise. Obviously, when someone exercises the option, then some seller will have to take the liability on the other side. This risk is randomly assigned to option sellers. Options assignment used to be a big risk when you sell options. However, since all stock options have become European options since 2011, this is no longer a risk for options sellers. Assignment is a risk that option sellers have to be conscious of in case American options get re-introduced at a later date.
4. Beware the overnight risk in short options positions
There are innumerable cases of overnight risks that have ruined the option seller. The most famous case is that of Barings in 1995. Their star trader, Nick Leeson, had sold calls and puts on the Japanese Nikkei index expecting the index to be in a range. However, when the Kobe earthquake struck Japan, the Nikkei crashed resulting in huge losses on the option sell trade. The trade resulted in a huge $1 billion loss which wiped out the entire capital of Barings bringing the 200 year old bank to bankruptcy. Even in India events like upper circuits and lower circuits have created huge overnight risk. It is advisable to avoid heavy short options position over long weekends, especially when scope for volatility is evident.
5. Selling options is a time/ price trade-off
This is the most critical thing to understand in selling options. When you sell options, time works in your favour as options are wasting assets and all OTM options tend to zero on expiry date. Option writers tend to prefer writing options in the beginning of the contract as it means higher time value and therefore higher premium. But that also means a higher risk of prices moving against you. It is this time / price trade-off that option selling is all about.
6. Ensure that you are adequately capitalized to handle margins
Buying an option is more straightforward. You pay the option premium and after that you are not really worried even if the price moves against you as your maximum loss is locked in. However, selling options is a different ball game altogether. When initiating an option sell position you have to pay initial margins like an open futures position. Additionally, there are volatility margins to be paid when the market risk goes up. Finally, there is the MTM (Mark to market) margin that you need to pay when the price movement goes against you. You need to be adequately capitalized to pay these margins and also factor the cost of funds into your option returns calculations.
Selling options is not rocket science. However, it is essential to be conscious of the risks entailed. That should be a good starting point for selling options!
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