You might be well aware that Options are capable of giving unlimited gains with limited risk if you are in the business of market trading for quite some time.For that,you need to buy an Option.If you have a bullish view for the underlying,you can buy a Call Option.Bearish securities can be played by buying Put Options.Doing so,all you risk is the Premium you pay for buying an Option.You can never loose more than that.Returns can be anything between 1% to 700% ( 700% is my personal highest gain for a trade which i played before result announcement for a stock in 24 hours) and it can be even higher than that.
Even though we can get such a high return as those magical figures in very short span of time,yet buying Options is not such a popular idea among the major players of the markets.In fact,they sell Options.Selling an Option is also called as ‘Writing’ an Option.You must keep in mind that by Writing an Option,you take Unlimited Risk while receiving Limited Gain as a return on your trade.Your gain while writing the Options is the Premium which will be credited to your account while a margin amount is blocked in your account.
Now you might be wondering if how come it is wise to get a limited gain and exposing yourself to unlimited risk while selling the Options?Moreover,the margin amount blocked in your account is much higher compared to the premium,you otherwise would have paid to buy an Option.It is like put more money in trade,take unlimited risk and get the limited premium as your profit.
For this we need to understand if how the Options trading works.You need to know that Option pricing also depends upon the Time Value in addition to the price of the Underlying Security.Time Value is the period left in Expiry of the Contract.At the start of each monthly contract,the Option prices are higher owing to long time duration before the expiry of contract.As the time moves on,the time left in expiry shortens leading to ‘Time Decay’ in Option price and hence fall in price of Option.Even if we assume that the underlying stock price remains same after one week,you will notice a substantial decline in Option price.Each passing day,be it a trading day or holiday,will cause time decay in Option price.
This is where the Option writers benefit by selling Options.Their trade is to sell the Option at higher price and buy back or square off the position at lower price,thus pocketing the premium.If you expect that markets are unlikely to give major up or down move,you can opt to write higher strike Call or Put options.If the market doesn’t give big move as you anticipated,you can get the entire premium at expiry day for that contract as you might be knowing that after expiry,the value of all Options becomes Zero.This strategy can be quite useful when the markets are range bound.In case of strongly trending markets,it is imperative that you identify the trend and take the trade accordingly.For strongly bullish markets,you can sell lower strike out of the money Put Options while in strongly bearish markets we can go for selling higher strike out of the money Call Options.
Another major benefit of selling Options is to eat the Volatility.This is the case while markets are waiting for a big news,like corporate results,elections results or a monetary policy announcement.Before the major news which might affect the future course of market move,you might notice that the Volatility starts rising and so are the Option prices.After the news is out,the volatility tends to come lower sharply which is of big advantage to the Option sellers and it is loss for the Option buyers.
The simple rule is that as the expiry date comes closer,if you could find out the tentative level for expiry of the market or any specific stock,you can simply go and sell ‘out of the money’ strike Options and wait till expiry when the prices comes to zero.
While doing all this,the point very important to keep in mind is to keep a strict stop loss in place for your trade.Always remember,Writing Options exposes you to unlimited risk.
Both speculator traders as well as investors sell the Options.The investors may do writing to hedge their portfolios against any adverse market move.Option writing should be done only after taking care of all the pre-requisites like research and your risk profile.If Option Writing is done like a professional,it can be a tool to get ensured return on your capital,the risks notwithstanding.Always remember :-
“Smart Players Never Buy Options.They Sell Options”