If you buy an option, you expose yourself to a limited amount of risk in the form of the option premium, but you expose yourself to an unlimited amount of potential gain if the price goes in the direction that you anticipate. When you sell options, on the other hand, your potential earnings from premiums are capped, but your exposure to losses is uncapped if the underlying asset's price goes in the opposite direction of your expectations. However, more than ninety percent of all purchased options become worthless when their expiration dates are reached. This effectively indicates that option purchasers are only successful in making a profit 10% of the time, whilst option sellers are successful in making a profit 90% of the time.
Keep in mind that the majority of option sellers are financial institutions, high-net-worth individuals (HNIs), and proprietary trading desks; these entities are typically more knowledgeable and make use of more advanced algorithmic trading strategies. While it is possible for smaller traders to sell options as well, there are a few considerations that need to be made before doing so.
The volatility works in your favour when you buy an option. However, when selling options, volatility works against you. This is especially true for the Nifty because the index is more subject to changes in volatility. For example, if you sold a Nifty 10,000 call option for Rs 60 and volatility rises, the option value could rise to Rs 70 even if the Nifty spot price remains unchanged. As a result, your option selling position suffers a notional loss. When volatility spikes, you must ensure that rigorous stop losses are followed.
When purchasing options, a stop loss may not be necessary unless you have paid a high premium for an ITM option. However, when you sell options, your risk multiplies because you have no downside protection. For example, if you had sold put options on ABC a day before CEO's resignation, your leveraged position would have resulted in massive losses on the day ABC fell 10%. In such cases, a stop loss is unavoidable in order to limit your losses. Even if you have to book a slightly higher loss than expected, it is preferable to losing your entire capital.
There have been numerous incidents of overnight risks that have destroyed option sellers. The most well-known example is the 1995 case of Barings. Nick Leeson, their top trader, had sold calls and options on the Japanese Nikkei index, anticipating a range. When the Kobe earthquake struck Japan, however, the Nikkei plummeted, resulting in massive losses on the option sell trade. The trade ended in a massive $1 billion loss, wiping out Barings' entire capital and forcing the 200-year-old bank into bankruptcy. Even in India, events such as upper and lower circuits have caused significant overnight danger. It is best to avoid large short options positions during lengthy weekends, especially if volatility is expected.
There are two options: American style or European style. Until 2011, all index options in India were European, whereas all stock options were American. A European option can only be exercised on the date of expiry, whereas an American option can be exercised on any date previous to the expiry. When an option buyer decides to exercise his option, he goes to the exchange and selects the exercise option. Obviously, if the option is exercised, some sellers will have to bear the liability on the opposite side. This risk is assigned at random to option sellers. When selling options, options assignment used to constitute a significant risk. However, since 2011, all stock options have been converted to European options, this is no longer a concern for option sellers.
Purchasing an option is less complicated. You pay the option premium, and then you are not concerned even if the price goes against you because your maximum loss is fixed. However, selling options is a completely different story. As with an open futures trade, you must pay initial margins when starting an option sell position. In addition, when the stock market risk rises, volatility margins must be paid. Finally, there is the mark to market margin, which you must pay if the price change is negative. You must be appropriately capitalised to pay these margins and also factor in the cost of funds when calculating option returns.
This is the most important concept to grasp while selling options. When you sell options, time works in your favour because options are wasting assets and all OTM options expire at the same time. Option holders like drafting options early in the contract since it indicates more time value and thus a greater payment. However, this increases the likelihood of prices shifting against you. Option selling is all about the price trade-off.
Through ideal options trading platforms like Option Brains accessible today, options trading has become quite simple. However, this does not imply that options online trading is easy. There are still things to consider and practise options trading apps to try before you dive in entirely. Find a trading platform that satisfies all of your options trading needs by offering a fluid learning trading experience. This should be your top priority when looking for a platform that suits all of your options trading needs as a beginner.
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