February 8th, 2022

Things To Look for When Selling Options

Just as options has dedicated buyers, it also has sellers.

Just as the option has a dedicated buyer, it also has a seller. After all, this is exactly what the market is all about, isn’t it? Now, the options buyer comes with a limitless profit potential and a limited risk prospect, the option seller lies in an opposite situation. As an option seller, your loss potential is pretty much unlimited, but your profits are limited to the premium you earn on the option. This does not mean that you stop dealing in options. But remember the following points when looking to sell options. 


#1 Taking a Contrary View and Not a Direct View 


An option writer or option seller needs to take a contrary view instead of a direct view. For instance, in case the option seller considers that the stock is not going to go below a particular level, the option writer starts selling a put option. At the same time, when the option writer thinks that the index or stock is not going to reach over a particular level, he starts selling a call option. 


#2 Understand the Risk Factor You’re Getting Into


The sellers of a call option and a put option have to face unlimited risk. Here's explaining the risk better for you to understand. For instance, if you have an XYZ 450 call option at INR 10, your highest profit is INR 10.  

However, when the stock prices increase and reach INR 470, your loss is going to be INR 10 [(470 – 450) – 10 premiums received]. Now, the reverse situation tends to work when the option seller goes ahead and sells a put option. Losses might be unlimited in either way. 


#3 the Risk of Assignment of Options for American Options


Options sellers also face the risks of assignment of options. This risk is mainly for the American options and not the European options. If we go by the above case, where the XYZ 450 call with INR 10 premium has risen to hit INR 470, it’s possible that some buyers might go and exercise this option.  When the option is exercised, the stock exchange randomly assigns the liability to the sellers. And when it is assigned to you, the net loss of INR 10 is faced by you. 

Thus, it’s always better for an option seller to necessarily trade with strict stop losses. Regardless of whether you’ve sold a put option or a call option, it’s always better to stop losses such that the capital remains protected. Also, the price of the option or the market price of the stock can also be used as a reference to set the stop-loss. 


#4 Calculation of an Initial Margin for Selling a Call Option


Keep in mind that when you try to see options, you’re liable to pay the margins like the futures position. Thus, when you sell call options, the initial margin is assessed the same way as it’s done for futures. There is no doubt that the margin is adjusted for premiums receivable.  

In addition to that, the sellers of the options are also liable to pay up the MTM margins and special volatility margins periodically, depending on the market conditions. The cost has to be factored in at the time of selling the options. 


#5 Look for Clear Market Trends When Selling Options


Selling options can work the best at a time when the market or the stock showcases a clear trend. For instance, if the RIL is showing a steady bullish trend, traders can earn profits by constantly selling the put options of high strikes. When you churn out your money more frequently, you can improve your profit through selling options when the stock price movement’s direction is pretty clear. 


#6 Weighing Between the Out-of-the-Money and In-the-Money Option


For an option seller, it’s the trade-off between the out-of-the-money option and in-the-money option. The latter gets you a higher premium but it comes with an equally high risk. On the other hand, the OTM option has a lower risk and comes with a lower premium potential. An option seller has to take the strike decision meticulously to make the maximum profit. 


#7 Option Sellers Leveraging the Best of Time Value


The time value tends to work in favor of an option seller. After you are done selling an option, premiums keep reducing with time to give the seller a chance to exit their position at a profitable stage by purchasing it back again at low levels. Therefore, the relationship of an option seller with time is in exact contrast to the option buyer, whereby the time goes against him. 


#8 Using Selling Options as a Cost Reduction Plan


Selling options are highly effective and efficient as a cost reduction plan through the use of covered calls. Let's offer two instances to clarify this case even further. If you had purchased ABC in the cash market at INR 350 and it’s down to INR 300, what are you going to do? Let’s say, you’re sure that in the next one year, the stocks are going to touch INR 450 because of a better profit performance. Also, even as you keep the stock, you get to keep selling the high call options. When the options expire nevertheless, the premium earned reduces the cost of holding ABC.  

Now, let’s consider the worst-case scenario where the stocks shoot up steadily. Then, you already have the long equity position as the hedge. Moreover, in option spreads, the selling options have a crucial role in bringing down the price of the purchasing options. 


#9 The Case of Expiring Options and the Associated Profits


It is worth remembering in this regard that globally about eighty to ninety percent of the options tend to expire worthless. So, the options seller has a higher chance of earning profits than an options buyer. Thus, you would note that usually it’s those large institutions and proprietary traders who turn out to be options sellers. On the other hand, the retail investors tend to be a bit more cautious at the time of selling options because of the skewed risk-return factor. 


#10 Consider the Implied Volatility in the Options Price


Implied volatility happens to be one of the most crucial determinants of the price of an option. Thus, it is important to get a thorough read about the levels of implied volatility for those options that you’re considering. Then, compare the levels of implied volatility with the historical volatility of the stock and the volatility level in the broad market. Thus, it will be one of the key factors in the identification of your option strategy. 


The Endnote 

Option selling isn’t as tricky and difficult as it seems when you set out on this path. Watch out for all the aspects mentioned above and options selling will be a lot easier for you. And the more you sell, you will gain more experience about the matter.