Which ‘Options’ will you pick?
First things first, before diving into the discussion of buying or selling an Option, let’s briefly understand the market of Options.
Let’s do it with the help of an example.
Let’s say you wish to buy this specific car in its flagship blue color that costs Rs. 5 lakhs. Now you go to the showroom and meet with a conundrum. At the showroom, you find out that the color you were so eager to buy, isn’t available this month and that the taxes for vehicles in the coming month may increase.
Now you’re in a dilemma and have to pick between another color and a lower price or the color of your choice but a possibly higher price.
So here’s when the dealer offers you a deal (I mean, that’s what they do right?) The dealer says that you could make a small payment right now, and reserve a blue color car for next month at the present day’s price. This way you get the color and also since you made the booking right now, you pay the taxes for this month. So you decide to make the payment of Rs. 10,000 right now and book the car. However, this does not include the cost of the car, and you’re essentially paying this amount just to be able to buy the car at the present day’s price in the next month. Let’s call this amount the ‘premium’.
Okay, so let’s consider the possibilities now. The taxes in the following month could either be more than the previous month, or less or the same.
If the taxes increase, it makes sense to buy the car so you instantly go and purchase the car by paying the Rs. 5 lakhs that was decided.
Now let’ say the taxes fall and the car now costs Rs. 4.5 lakhs. In this case, it makes sense to let go of the premium that you paid and buying the car at the current market price since you still save Rs. 40,000.
If the taxes remain the same, you still stand to lose, but only the premium amount of Rs. 10,000.
The Options market works much in the same way. A buyer and a seller make a contract for a transaction for a future date.
As you may have realized in the car example, if the price of the car fell, you had the option to not go ahead with the deal, letting go of only the premium that you paid.
However, if you did go ahead, the car dealer would have to sell the car to you at the pre-decided price.
This phenomenon in the Options market is called the Call Option, wherein the buyer of the Option reserves the right to buy and the Options seller must comply with the decision of the buyer of the Options.
The other Option in the market is the Put Options, wherein the buyer of the Options reserves the right to sell and the seller of the Options must comply with the decision of the buyer of the Options.
Multiple factors are considered while deciding whether to buy or sell an Option. Here are a few things to keep in mind:
In the case of the buyer in a Call Option, the maximum loss is the premium paid (in case they do not continue with the contract at the decided date), while the profit is unlimited since the price of the underlying asset can go up to any amount while the buyer gets to buy it at the decided amount. The Call seller may lose an unlimited amount and can earn up to the premium received.
On the other hand, in a Put Option, in a similar way, the buyer will earn when the price of the underlying falls.
Volatility rocks (the prices of the shares)
One school of thought also believes that 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. Options prices (premium) are likely to rise with an increase in volatility.
When predictions become the deciding factor
If you have a defensive view, for example, if you are sure of a stock price not going above Rs. 500 or the price is likely to move within a small range, then it is better to sell a Rs. 520 Call Option than buying a Call Option.
Events: cents or dents
It also depends on the events that take place. It is not advisable to sell Options ahead of a significant event where you expect a considerable upside or downside in the prices. Option selling could be disastrous in those cases.
It would be better to look out for buying Options in such times.
In all, there is no definitive conclusion as to whether buying or selling an Option is inherently better than the other.
It all depends on your willingness to take risk, and the factors discussed. While the risk would be higher or lower depending on your position, this does not account for the probability of the price change being in your favor or not.
- In Options, buyers have the choice of not exercising their right if it is loss bearing.
- In a Call Option, the buyer has the right to buy the underlying, while in a Put Option, the buyer has the right to sell the underlying.
- The buyer of an Option faces a loss only equal to the premium paid, i.e., limited loss, whereas the profit can potentially be unlimited.
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