4 Things to Consider While Selling Options
Every financial transaction needs to have at least two parties – a buyer and a seller. The same holds good for derivatives, including options. Options trading is a risky affair, but it is especially risky for options sellers. That is because the loss potential while selling options is unlimited. Then why engage in selling options?
It is often said that options are meant to be sold. Worldwide, it is primarily regarded that 80% of options expire worthlessly. That means that it is profitable to be an options seller. Nevertheless, the risk in selling options is still high, so an options seller needs to have a solid options selling strategy before entering the trade.
What is Options Selling?
An options contract is a derivative contract between two parties to buy or sell an underlying asset at a predetermined price on a particular date in future. The buyer of an options contract has the right but not the obligation to fulfil the contract. The seller, however, has to honour the contract if the buyer exercises their right. The seller receives a premium on the options contract for assuming this risk.
Additional Read: Options Trading Strategies for the Indian Market
A seller can sell two options – a call option and a put option. A call option obligates the seller to sell an underlying asset at a particular price. A put option binds the seller to buy an underlying asset at a specific price.
Very often, options are not exercised, and they expire worthlessly. That means that the seller will profit from the transaction. The other exciting thing with options is that the value of an options contract declines as time passes. Therefore, you can book an offsetting trade at a lower premium and profit from it as an options seller. Yet, an adverse market movement can result in a massive loss if you don’t have the requisite options selling strategy in place. There are undoubtedly other considerations that you must make while selling options. Here are four aspects to consider before you get into options selling.
Four Things to Consider While Selling Options
- As an options seller, you take a contrarian view of the market. You believe that the underlying security will end up at-the-money or out-of-the-money, and the options contract will expire worthlessly. For instance, if you think that an underlying price will not dip below a certain level, you will sell a put option. On the other hand, if you believe that the underlying will appreciate, you will sell a call option. You must be clear about this before selling options.
- The risk assumed when selling options are unlimited. When you sell a call option, there is a possibility that the price of the underlying will go up infinitely. When you sell a put option, theoretically, it is possible that the price of the underlying can go down to zero or near zero. In these cases, the risk that you are assuming as an options seller is high.
- Options sellers have to pay margins just like any other derivatives trader. When you sell a call option, there is an initial margin that you will have to pay. The margin does get adjusted for the premium received. Moreover, you will also have to pay MTM margins and any other volatility-related margins from time to time. Don’t forget to factor these costs in when you are selling options.
- Since selling options involves so many different variables that could result in unlimited losses, it is always advisable to trade options with a stop loss in place. A stop-loss is designed to limit the amount of losses you make. Selling options without a stop loss is akin to driving a car without airbags.
Additional Read: Key Differences between Options and Swaps
While selling options is often a strategy that institutional investors and large traders employ to limit risk or make profits, it is a route that retail investors can also consider. However, this must be done with adequate risk management tools in place. If you want to start trading in options, reach out to the nearest SEBI-registered broker to start on your journey.
Disclaimer -ICICI Securities Ltd.( I-Sec). Registered office of I-Sec is at ICICI Securities Ltd. - ICICI Centre, H. T. Parekh Marg, Churchgate, Mumbai - 400020, India, Tel No : 022 - 2288 2460, 022 - 2288 2470. Please note, IPO related services are not Exchange traded products and I-Sec is acting as a distributor to solicit these products. ICICI Securities is also a BRLM to the issue. The contents herein above shall not be considered as an invitation or persuasion to trade or invest. I-Sec and affiliates accept no liabilities for any loss or damage of any kind arising out of any actions taken in reliance thereon. Investments in securities market are subject to market risks, read all the related documents carefully before investing.