Personal Finance

The gains and risks in selling options

B. Venkatesh | Updated on July 16, 2011 Published on July 16, 2011

Individuals typically buy options to gain from the price movement in the underlying. But there are some factors to be considered for optimal trade set-ups.

Individuals typically buy call and put options. It was, hence, surprising to receive a query from a reader who wanted to know if individuals can consider selling (shorting) options as a strategy within the satellite portfolio. The question is: Is it optimal for individuals to sell options?

This article discusses the gains and the risks associated with selling options. It then suggests optimal set-ups based on market conditions.

Options are quite unlike most other financial instruments available in the market. The maximum loss for a call or a put buyer is the premium paid to buy the option. The maximum profit for a call buyer is, however, unlimited and for a put buyer is high.

The reverse is true for the option seller. The risk is unlimited for call seller and high for put seller. The maximum profit for call and put seller is just the premium collected. This skewed risk-return trade-off for option sellers is referred to as asymmetric payoff. Clearly, option selling appears to be a losing proposition until we consider time decay.

Options lose value (called time decay) as they approach expiry. The skill is to sell options that decay faster or expire worthless. Empirical evidence suggests that most option buyers typically close their long positions well before expiry due to the problem of time decay. Longer the option seller holds the option, greater the chance of time decay.

This is logical considering that all out-of-the-money (OTM) and at-the-money options (ATM) expire worthless.

There are gains to be made by selling options. A cause for concern is that option selling is a negatively skewed strategy. Option sellers are likely to make small frequent gains as options often expire worthless. The sellers are subject to large infrequent losses when options are exercised or when short options have to be covered at a higher price. It is important to understand factors that can help moderate such infrequent large losses and increase the likelihood of small gains.

Key factors

Option sellers should be concerned about timing their entry. The decision to take profits is not important, unless the seller prefers to close the position well before expiry. This is because the position is deemed closed at expiry.

Given time decay, individuals would do well to sell options favouring the trend. If the underlying index or stock is positive, individuals should consider selling calls, not puts. For one, it would be unattractive to sell puts, as premiums will be low when the underlying is positive. For another, it would be a matter of time before underlying reverses direction. So, selling into the trend will help individuals capture the high premium. Reading the open interest positions in puts and calls may be useful. Novice traders typically buy options while professional traders sell options. A higher open interest in puts compared with calls could suggest that the novice traders are buying more puts than calls, perhaps, because the underlying is already declining in value. Option sellers can, thus, consider selling puts to capture the high premium.

It is optimal to sell OTM options to minimise associated risks from short position.

To further reduce risk, individuals can consider setting up credit spreads. This involves selling lower strike call and buying higher strike call or selling higher strike put and buying lower strike put. In both cases, cash inflow from selling options will be higher than the outflow from buying. It would be optimal to sell options when the volatility is high.

Selling options carry high risk but limited reward. Individuals should consider the risks before such trades. Option trading strategies form part of the satellite portfolio and should not be more than 10 per cent of capital.

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