Hello Guys! I hope you are doing good. I have seen many time novice traders start their options trading with selling options. But unfortunately, end up with huge losses. In today’s article, I’m sharing 5 facts about options selling, every option trader should know before they start their options trading journey.
These 5 facts, only help you to understand options better but will help you to limit your losses so that you can earn from Option selling. So read this post till the end to know these 5 facts about options selling. If you have any queries, you can type in the comment box. I love to solve all your queries.
What is Options Selling?
The seller of an option, also known as a writer who sells an option to collect the premium from the buyer. A writer can sell a call option or a put option whether covered or uncovered. Naked Option is another name for an uncovered position.
For example, if an investor has 10 shares of a stock can, he may sell a call option on the shares so that he can get the premium from the buyer. The position is called a covered position in this case because the seller owns the underlying asset and sells the shares at the strike price. In a covered put option, the investor shorts the shares and writes a put. In an uncovered option, the seller faces the risk of a loss if the underlying asset moves in an undesired direction.
Covered call writing can result in either of the three outcomes. If the options expire worthlessly, the seller keeps the entire premium after selling the option. If the options are going to expire in the money, the seller has two options. The seller can sell the underlying shares at the strike price to the buyer or the seller can buy the option.
Selling uncovered calls results in the same positions except if the share price closes in the money, the seller has to either buy stock on the open market to give the buyer or close the position. The loss is the difference between the strike price and the market price of the underlying asset added to the premium which was received before.
In this type of option when the seller shorts the underlying stock, the position is covered if there is a corresponding number of shares sold short in the account.
In case of an uncovered put position, the seller can buy the underlying shares at the strike price or buy the option. If the seller buys the underlying shares, the loss suffered can be calculated as the difference between the strike price and market price, minus the premium received before.
To help you with selling options, this article presents 5 Facts that would be helpful while proposing a strategy.
5 Facts About Options Selling
When to Sell/Write an Option?
Option sellers are also called Writers. Selling options create profits in the case an investor gets paid the option premium upfront and hopes the option expires worthless. The profit in selling options increases as time passes and thus, the value of the options decrease. A seller has to be careful it is risky to sell options when the market moves untimely.
Selling Call Options
The most important point in call options is that the seller of a call option is not obligated to sell the option even if the buyer exercises his right.
The price of an option that a seller receives is based on the estimation of how likely the option buyer would make a profit by exercising his right to purchase. This is usually estimated by how close the strike price is to the underlying asset’s price when the option is bought and the time remaining for the option’s expiration.
For a seller, the main fact to check while selling a call option is to check if the asset’s price is declining and if the option would probably become valueless before the time of expiration. If this happens, the seller keeps the premiums as profit. Hence, the ideal time to sell call options is when the seller estimates that the asset’s price would not increase before expiration from the said time.
Selling Put Options
The main reason behind selling a put option for a seller is to get the premiums and benefit from the bullish sentiments of the market.
Seller sells an option with the hope that the option may lose value so that the seller can collect the premiums from the option. After a put option has been sold to the buyer, the seller is obligated to buy the underlying asset at the strike price once the option is exercised.
Put Options Seller can earn a profit when the spot price is equal to or more than the strike price. A seller must sell a put option when he believes that the underlying asset’s price would not fall any further.
Tip for the Reader: Strategize to sell the option when the difference between the strike price is closer to the underlying asset’s market price whilst the time for expiration is relatively closer.
Sell Using the Implied Volatility
It is always good for the Option sellers for the price of the underlying asset, say stocks, to be confined in a narrow trading range, or move in the seller’s favour. Thus, it is very important to understand how volatility is crucial for an options seller. Sellers can use Implied Volatility to profit.
As talked about in the earlier articles, Implied Volatility shows the expected movement of the underlying asset in the future. Implied volatility can be thought of as the market’s expectation of the movement in a security’s price. It decreases when the market is bullish, and investors believe that prices are likely to rise in the foreseeable time.
The premium of an option increases If a stock has high implied volatility.
It is not an unusual scenario in the market when at one point an option seller is short on a contract and there is a sudden rise in the demand for contracts in the market. This increases the price of the premium and may even cause a loss, even in the case where the stock doesn’t move much.
When there is a rise in the levels of implied volatility, the investor should consider selling the options. As the premium of the options relatively increases, it is more profitable to sell the option. Keeping track of implied volatility helps an option seller with an upper hand by selling the options when the implied volatility is high.
Time decay also has an effect on the sensitivity of Implied Volatility. The closer the strike price is to the stock price, the more likely is the Implied Volatility to change.
Tip for the Reader: Higher the Volatility, higher the premium for the seller.
Probability of Success
As talked about in the earlier articles, keeping Greek Delta in check while buying options is helpful. It means a change in the option’s premium, which is expected to happen with a percentage change in the underlying stock’s/index price.
An option seller can also use delta to determine what is the probability of success. For example, if the value of Delta is 1.0, it means that it is a 100% chance that the option will be in the money by expiration even if it is at least INR 1. Similarly, a 0.30 delta has about a 30% chance that the option will in the money at the time of expiration.
When selling, the probability of making a profit is as high as the measure or extent to which the option is out of money because it decreases the threat that the seller will be assigned in case the contract is exercised.
In some cases, the option seller has to decide if he wants a greater probability of success or a greater premium from selling the option. This has been discussed further in the article.
It is important to remember that premium pay-outs would be lower if a lower delta accompanies the strike prices.
Although, various factors other than delta, can be used as a foundation for calculations using delta in calculations is based on implied volatility and thus, gives investors a better position than others in the market.
Tip for the Reader: More the value of Delta near the expiration of the contract, the higher is the chance to score a better profit.
Taking Advantage of Time Decay
With the nearing date of expiration, the value of an option decreases. This phenomenon is known as Time Decay. The Greek Theta is a measure of time decay. It is not unusual for a stock to move around in almost different directions and thus, the time value goes and comes back.
Both types of Options Calls and Puts have the value of Theta negative because the options lose value with time. For a seller, Theta is positive. For option buyers, the options lose value from day one, but for the seller, the position will be positive in Theta.
This criterion is not the same for ‘At the Money’ (ATM) and ‘In the Money’ (ITM) options. For ITM options, the time is very little. These options slowly move towards their intrinsic value, losing their time value. Thus, the decay for ITM options is rather slow. On the other hand, the decay is different for ATM options. Usually, in an ATM option, the value of Delta is 0.5 and the strike and stock prices are almost equal. These options decay very slowly till about six weeks until the date of expiration and then pick up the pace.
As Time Decay begins to accelerate, sellers try to make use of the time value, so sellers usually stay within and wait for a period of six to seven weeks. It is possible to go further out in time and this would bring in more premium for the seller, but the problem is that rate of Time Decay after this period is usually very slow.
The rate usually picks around 45-50 day time frame and it continues to increase through expiration. But in this while, the value of the option is also decreasing as expiration reaches closer. Thus, with the Decay factor, the time of expiration has to be taken care of Those two things have to be balanced
Tip for the Reader: Time decay also affects other factors like IV and even Delta and thus should be carefully weighed upon.
Picking the Right Strike Price
We have discussed in the earlier articles that for a call or a put buyer, estimating the right strike price is very important or the investor might lose the full premium paid.
For a call seller, choosing the wrong strike price may cause the seller to lose the underlying stock. On the other hand, if a put seller chooses the wrong strike price would cause the underlying stock to be assigned at prices higher than the market price. This occurs when the stock price falls altogether, or when there is a shocking market sell-off, causing share prices to fall.
Depending on the type of option being sold, the strike price should be chosen based on the volatility of that underlying stock or index and the investor’s risk-taking limit. For an investor, the risk-reward payoff is defined as the amount of money the investor is ready to risk on the trade and its projected profit.
The higher the volatility of the underlying asset, the better chances for a profit in selling. An investor’s risk profile is related to the strike price while trading an option.
Moreover, the closer the option is to the date of expiration, the higher the premium. Thus, the time value, as well as the intrinsic value of the option, have to be considered while deciding a strike price along with keeping the volatility in check. Similarly, using Greek Theta while estimating the right strike price is also helpful.
Tip for the Reader: The seller must not get too close to the expiration date to determine the Strike Price as it may cause the chance to make a better profit left unused. The time frame of six to seven weeks is the most appropriate.
A Bonus Fact! – Hedging
Hedging is a useful technique that is frequently used by traders not only for options but for other investments too. The basic use of hedging is that it reduces the risk of holding one particular investment position by taking an opposing position. Options traders hedge positions, by gathering an opposing position. Hedging is a form of insurance for the investor. If you take insurance on a car, house, or other property you own, then it protects you from the risk of loss or damage to your assets.
Hedging is not an investment technique. It is used to reduce losses. There are several reasons to use hedging, the foremost being to protect the portfolio. It is also used to protect against uncertain circumstances in the market and potential volatile investments.
Using options for hedging is quite easy. Many investors usually use options to hedge against their investment portfolios which may consist of other investments such as stocks, ETFs, etc. Strategies, such as covered calls and protective puts can be used for hedging to minimize risk.
Using options to hedge against the existing portfolio mostly involves buying or selling opposing to protect the current position. For Hedging, the two related investments must have negative or of opposite relations so that when the value of one investment falls, the value of the other rises.
Let’s say an investor buys a stock of Company A. For an effective hedge, the investor can buy puts on Company A’s stock.
Spreads is also an important part of most options trading strategies which helps to reduce the starting cost of taking a position and somewhat the risk of taking that position. Although this is not the specific use of spreads, it is still a form of hedging.
I hope now you have understood how important these 5 facts about option buying are. If you any query related to these 5 facts about option buying can type in the comment box.
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DISCLAIMER: – we are not a SEBI research analyst. Views posted here only for educational purposes. There is no liability whatsoever for any loss arising from the use of this product or its contents. This product is not a recommendation to buy or sell, but rather a guideline to interpreting specified analysis methods. This information should only be used by investors and traders who are aware of the risk inherent in securities trading.