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How to decide whether to buy or to sell an option?

Back in 1994 a star trader called Nick Leeson was creating waves at Barings. Around late 1994 he decided to take a view that the Japanese Nikkei index would be in a narrow range. Hence he decided to sell strangles on the Nikkei i.e. he sold lower puts and higher calls. By September 1994 he had built up massive positions creating short strangles on the Nikkei. Then in September 1994 a massive earthquake struck Kobe and the Nikkei crashed. For Nick Leeson the short calls had a happy ending but he got battered on his short put positions. When the losses got exposed it wiped out entire capital of Barings and the 150 year old bank had to file for bankruptcy.

While the above case exposes the lax levels of risk management, it also underscores the importance of the decision whether to buy or sell options. Had Nick Leeson bought the strangle on the Nikkei instead of selling the strangle, then Barings would still be alive; but that is a different story altogether. The question is whether there are options trading tips and tricks to decide when to buy and when to sell options? What should be your call option trading strategies? Here is a beginner’s guide to option trading identifying factors that can help you to decide when to buy and when to sell an option.

Whether the option is overpriced or underpriced
How do you decide whether an option is underpriced or overpriced? Like in the case of equities, you will have to calculate the intrinsic value of the option. Obviously, you cannot calculate the intrinsic value of an option the way you calculate the value of equities. But there is a separate model called the Black & Scholes model which has a complex formula to help you calculate the intrinsic value of any option. For now, you need not get into the intricacies of the formula as the Black & Scholes is available on your trading terminal itself. 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 underpriced and needs to be bought.

Whether the volatility is going to increase or decrease
This is an important factor while deciding whether to buy or sell options. Both call and put options benefit from volatility because it makes the option valuable on the upside but your downside risk is limited anyways. 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.

Are there major events with deep impact potential?
Can you imagine what would have happened if you had sold put options ahead of the Lehman Brothers crisis or the Greek crisis. Ahead of major events or key geopolitical risks it is always better to be on the buy options rather than to sell options. By buying options at the most you will lose the premium and nothing more. As we saw in the case of Barings and Nick Leeson, if you sold options ahead of cataclysmic events then your capital could get wiped out.

Whether we are taking an affirmative view or a defensive view
What is your view on the stock or the index is a very important factor that determines the decision to buy or sell an option. An affirmative is when you either expect the stock to decisively go up or decisively go down. In that case you either by a call option or a put option as the case may be. But what if you have a defensive view? For example, if your view is that Tata Steel will not go above Rs.720, then it is better to sell a 730 call option on the stock rather than buying the option.

What is the time left to expiry?
This is a very important determinant of whether you should be buying or selling an option. Remember, all option contracts have a fixed date of maturity. Time works against the buyer of the option and in favour of the seller of the option. In the initial days of the month the time decay is normally quite stable. But as the expiry date approaches, you find the time decay beginning to work more rapidly. That means the option starts losing value rapidly. Hence closer to expiry it is not a very good idea to buy options unless you really want to take a risk and bet on volatility.
Whether to buy or sell the option is an important decision. The more your decision is thought through, the greater are the chances of your success.


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