How Option Selling Works?
Option selling in the world of stock market trading is like a high-wire act – thrilling, but also a little nerve-wracking. On the one hand, where option buying is all about investing in options, sellers make a profit in option trading by earning a premium. But to be a successful option seller it is important to understand its ins and outs. Let’s begin with detailed information on how option selling works.
So if you’re ready to take on the challenge, buckle up and prepare for the ride of your trading life!
Option selling involves writing options contracts and collecting a premium upfront. This strategy can be used in a variety of market conditions and has the potential to provide consistent returns. However, it also carries some risks, and investors must be aware of the potential downsides before selling options in the market.
How Option Selling Works in India?
Options are of two types, call option, and put option. If you are bullish toward a particular trade, you sell a put option on the other hand, bearish traders sell a call option. For the selling option, you earn a premium and thus are obligated to settle the trade at a pre-determined price called strike price on the expiry day.
Let’s understand this with an example.
Assume that a property builder comes with a contract for the buyers offering the flat at the current market value of 50 lakhs after 2 years. For this contract, the builder asks for the upfront non-refundable amount of ₹50,000.
Now before moving ahead, let’s discuss the scenario in which he will write that contract.
- The real estate market may decline.
- The property rate is not as it seems to be.
Since he has the risk of losing a profit in the future he comes with the contract with the offer for the buyers to book a flat by paying a non-refundable deposit of ₹50k and in return the buyers get the right to buy the property at the lower rate in case the price goes up.
Here the builder will earn profit and will be able to keep the whole amount of 50k if the property prices stay in the range or decline by the time of delivery.
Similar to this, if the market does not move or is slightly trending the option seller sells an option contract and earns the premium value as a profit.
Option selling is also known as writing options or shorting options. The strategy is popular among traders who believe that the price of an underlying asset will not move significantly shortly.
Generally option sellers open new positions in the neutral market but the trending market also brings in an opportunity for them to earn money. To become a pro option trader one needs to understand various concepts of the market, like analyzing trend, understanding market volatility, determining candlestick pattern and getting a through understanding of what does option chain indicate.
All these parameters, eventually help an option writer to determine the risk-reward and to safeguard the selling position.
How Does Selling a Call Option Work?
Call option sellers are obligated to sell the underlying assets at the predetermined price on the expiry date. They earn and keep the whole premium value if the market falls.
Since option sellers do short selling they also make money by the declining premium value and therefore choose the option with high theta value.
Let’s understand with an example how the call option works:
Suppose Nifty is trading at 17200 and Mr. X wants to sell the option. Seeing the market trend and as per his analysis, he is strongly bearish and therefore sells the call option at 17300 at ₹70.
This means if the Nifty value goes beyond 17300 then he is obligated to settle the trade with the buyer, but if the value declines then he will earn profit by keeping the whole premium amount.
Even if the market does not move, the time value of the premium decreases which leads to the profit of the option seller. This is one of the major reasons why option buyers lose money.
The loss is calculated by determining the intrinsic value which is:
=Spot Price – Strike Price
On the other hand, if he does not want to wait till the expiry date, he can exit his position by placing the buy order.
Let’s say the Nifty value decreased by 50 points i.e. the market moves as per his analysis, the premium value will decrease too.
Suppose the new premium value is ₹50, Mr. X will place the buy order and exit the position by making a profit of ₹20.
How Does Selling a Put Option Work?
Put option sellers are bullish on the market and are obligated to buy the underlying asset at the predetermined price on expiry.
Let’s now understand the concept of put-option selling with an example. Suppose Mr. X is bullish towards the market when Nifty is trading at 17000. He then sells a put option 16800 and earns a premium of ₹100.
Here if the market falls beyond 16800 then he is obligated to settle the trade, however, if the Nifty value increases, then he will be able to keep the whole premium amount.
The loss is calculated by calculating the intrinsic value which is:
= Strike Price – Spot Price
Also, as discussed above, he can exit his position by buying a put option at a low premium value in the bullish market.
Option selling is risky as they tend to lose the premium amount if the market moves in the opposite direction. To prevent such a scenario, most option sellers prefer to open the position at the strike price with a lower delta value, i.e. OTM options.
However, the premium value is quite less for OTM options hence profit percentage is low. Another way to minimize the losses, especially in call option selling is to use the covered call strategy.
Covered Call Strategy
In the Covered call strategy is useful in the case of selling stock options where a trader sells call options on an underlying asset they already own.
If the call option seller is bearish towards the stocks he holds, he sells the call option to earn the premium and an obligation to sell the underlying asset at the pre-determined price (strike price).
Here the strike price is generally higher than the value at which the seller bought the shares and the current market price of the stock.
The reason here why, the seller is “covered” is because they already own the underlying asset, so they can deliver it to the buyer if the option is exercised. If the price goes beyond the strike price, he is obligated to sell the shares and in case it falls or trends in the range, the seller will be able to keep the premium amount.
Covered option selling can generate income for the seller, but it also limits their potential gains on the underlying asset if its price rises above the strike price.
How Option Sellers Make Money?
There are different opportunities in front of the seller to earn money. Here we have discussed 5 ways by which an option seller earns profit in the stock market:
1. They Collect Premiums
As Option sellers collect premiums from buyers in exchange for the right to buy or sell an underlying asset. The premium is their profit, which they keep if the option expires worthless.
2: Time Decay is in Their Favor
Options have an expiration date, and they lose value over time. This is known as time decay. Option sellers earn profit by selling options with a short expiration date. As the option approaches expiration, its value decreases, allowing the seller to keep more of the premium.
3: The Probability of Profit could be More
Option sellers can increase their probability of profit by selling options that are out of the money, meaning the strike price is above the current market price for call options or below it for put options. This increases the likelihood that the option will expire worthless and the seller can keep the premium.
4: They use Hedging Strategies
Option sellers can use hedging strategies to reduce their risk of losses. For example, they may sell options with a strike price close to the current market price and simultaneously buy options with a higher strike price to limit potential losses.
5: Market Volatility can be Beneficial for Them
Option sellers can benefit from market volatility by selling options when the market is highly volatile. This is because the higher the volatility, the higher the premium the seller can charge. However, this strategy also carries higher risks, as a sudden and significant price movement can lead to large losses for the seller.
While option selling has its benefits, it also comes with risks, and traders should have a good understanding of the market before attempting this strategy. You can gain knowledge and understanding by reading books on options trading or by joining option-selling courses.
Also, to begin option selling, one must have enough capital to maintain the margin and fulfill MTM requirements in the trading account. In short, if you are looking to start option trading with 1000 rupees or less amount, then selling is not an option for you.
Along with options selling, there are several trading types that you can learn through our online trading courses. The future of trading is bright when you know how to analyze the market and its trends.
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