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A Primer on Single Leg Option Positions

24 Feb 2022 0 COMMENT

Stock market trading involves an exchange of financial instruments like stocks, bonds, and other securities. Naked options are investments for speculators with a great appetite for risk. Options traders can take the long and short position in Call and Put Options as per their view on the market. For Options buyers, a maximum loss could be of premium paid. However, options sellers are not protected or hedged and can have extreme losses in adverse market movement.

A futures contract is an accord to buy or sell an asset at a particular time in the future. Options contracts are not rigid and inflexible like futures contracts. At the end of the agreed-upon time, the option can expire worthless, with no action done by the buyer. If the buyer insists upon executing the transaction, the seller has no choice or say in the matter. Futures and options are legally binding contracts designed in different ways. Options give buyers the right, not the obligation, to exercise their right to buy or sell.

Call Option is a financial instrument that gives the right to a buyer to buy the asset at a pre-decided price on expiry of the contract. Option buyers pay the premium to the option sellers to purchase the right. The seller expects it to expire, at the end of the specified period, worthless. Thus, on selling it, the trader has made an overall profit from the deal in terms of the premium received. In the case of a naked short call, a trader expects a decline in the price of the asset. The strike price is the price of selling the option at the end of the period, if buyer of the option insists on buying it. A person cannot know how high the price of the stock will be at a certain time. Thus, theoretically, such trades have infinite potential for loss if the stock starts moving upwards. However, if the stock price rises beyond its strike price, the seller may buy back the option before the loss goes beyond his or her risk appetite.

Put Option is a financial instrument that gives the right to a buyer to sell the asset at a pre-decided price on expiry of the contract. Naked short put options are made by traders who forecast that the value of the stock will rise. The trader is moderately bullish about the market. These options have a limited upside and a theoretically infinite downside risk. In this case, the strike price is the price at which the share is bought at the end of the expiry period, if buyer of the option insists on selling it. Thus, if the option expires worthless (that is, the price rises, as the seller had predicted), the profit made is the premium received on each share. Shorting of the options is made for the sole purpose of earning a premium.

Thus, naked short call and put options are high-risk bets, and require margin to be paid to take these positions. It is possible to employ few rules to mitigate the risk. For example, stop-losses can be applied as a protective measure not to incur higher losses.

We can summarise the naked option position in the following table:

 

 

Call

Put

Buyer

 

Strongly bullish

Strongly bearish

 

Right to buy

Right to sell

 

Pays premium

 

Unlimited profit*

 

Loss limited to premium paid

Seller

 

Mildly bearish

Mildly bullish

 

Obligation to sell

Obligation to buy

 

Receives premium

 

Profit limited to premium received

 

Unlimited loss**

 

* In the case of Put buy, profit is restricted to fall in the price of the underlying asset less premium paid

** In the case of Put sell, loss is limited to the fall in the price of the underlying asset less premium received

Despite the high loss potential, such trades are regularly done on the market by experienced traders. The potential for loss is a huge detractor for casual investors. Professional options traders exist because mastery of such trades requires capital, patience and discipline. Ultimately, all investors are looking to make a profit and the path taken by each one need not be the same.

Choose your path well.

We hope you enjoyed reading this article! Until next time, happy investing!

Key takeaways:

  • A short call is in the range of bearish to neutral options trading strategies. It takes advantage of downward price movement of the asset. A long call, on the other hand, is a bullish options trading strategy that takes advantage of upward price movement of the underlying asset.
  • A long-put strategy would be used if an investor (taking up the role of the option holder) expected the stock’s price to decrease. A short put strategy would be used if an investor (taking up the position of the option seller) expected the stock’s price to increase mildly or remain stagnant.

Disclaimer:

ICICI Securities Ltd. (I-Sec). Registered office of I-Sec is at ICICI Securities Ltd. - ICICI Venture House, Appasaheb Marathe Marg, Prabhadevi, Mumbai - 400 025, India, Tel No: 022 - 6807 7100. I-Sec is a Member of National Stock Exchange of India Ltd (Member Code :07730), BSE Ltd (Member Code :103) and Member of Multi Commodity Exchange of India Ltd. (Member Code: 56250) and having SEBI registration no. INZ000183631. Name of the Compliance officer (broking): Mr. Anoop Goyal, Contact number: 022-40701000, E-mail address: complianceofficer@icicisecurities.com. Investment in securities market are subject to market risks, read all the related documents carefully before investing. 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. The contents herein above are solely for informational purpose and may not be used or considered as an offer document or solicitation of offer to buy or sell or subscribe for securities or other financial instruments or any other product. Investors should consult their financial advisers whether the product is suitable for them before taking any decision. The contents herein mentioned are solely for informational and educational purpose.