Learn Options Selling

Option Selling:

Understanding Option Selling Trading: Key Concepts of Options

Option Selling and Option Buying involves a time-bound contract between two parties: the option buyer and the option seller. A call option is a popular type of options contract where the option seller believes that the underlying asset’s price (known as the “spot price”) will not exceed a specific price level (called the “strike price”) by the contract’s expiration.

In a call option, the option seller receives a premium from the option buyer in exchange for the right to buy the underlying asset at the strike price. Here’s how it works:

• If the spot price settles above the strike price at expiration, the option seller must pay the difference between the strike price and the actual price, thus incurring a loss.
• If the spot price remains below the strike price at expiration, the option buyer loses the entire premium paid for the option.

Risk and Reward in Call Options Trading

• Option Buyers: The risk for an option buyer is limited to the premium paid for the option, while the potential profit is theoretically unlimited as the price of the underlying asset rises above the strike price.
• Option Sellers: On the other hand, option sellers face unlimited risk if the underlying asset’s price rises significantly above the strike price. However, their profit is limited to the premium received for selling the option.

Key Takeaways:

• Limited risk for buyers, unlimited risk for sellers.
• Profits for buyers can be unlimited, while sellers’ profits are capped at the premium received.

Options trading strategies, like buying call options, are often used to hedge or speculate on price movements. Understanding the dynamics of option premiums, strike prices, and expiration dates is crucial for anyone looking to engage in options trading

Factors Affecting Option Premiums in Options Trading

The option premium is the price that an option buyer pays to the option seller for the rights conferred by the options contract. The value of the option premium is influenced by several key factors, including:

1. Time to Expiry: The more time there is until the option expires, the higher the option premium. This is because more time provides greater opportunity for the price of the underlying asset to move in a favorable direction.
2. Strike Price Relative to Spot Price: The closer the strike price is to the spot price (the current market price of the underlying asset), the higher the option premium. As the strike price moves further away from the spot price, the premium generally decreases.
3. Volatility: Higher volatility in the market or the underlying asset increases the likelihood of significant price movements, which in turn raises the option premium. Traders are willing to pay more for options in volatile markets due to the potential for larger price swings.
4. Price Movement of the Underlying Asset: If the underlying asset price moves in favor of the option buyer (i.e., in the direction that benefits the position), the option premium typically increases. Conversely, if the price moves against the buyer, the premium may decrease.

Example: Strike Price 5% Above Spot Price

Let’s say an option buyer selects a strike price that is 5% above the current spot price. In this case, for the option to become profitable, the price of the underlying asset needs to rise above the strike price by more than the initial premium paid.

In other words, the option buyer must recover both the strike price plus the premium paid for the option to make a profit. If the underlying asset’s price does not exceed the strike price plus the premium, the buyer may experience a loss.

Summary of Key Factors Influencing Option Premiums:

• Time to expiry: Longer time frames lead to higher premiums.
• Strike price proximity: Closer strike to the spot price increases the premium.
• Market volatility: Increased volatility leads to higher premiums.
• Movement in favor of the buyer: Price movement in the buyer’s favor raises the premium.

Understanding these factors is crucial for anyone involved in options trading, as they help traders assess the potential costs and rewards of different options strategies. Whether you’re buying or selling options, being aware of how these factors affect option prices will allow you to make more informed decisions.

Example – Spot = 100, Strike = 105, Premium = 1.

If spot closes 110, then option seller has to pay 110 – 105 = Rs. 5 to option buyer.

If spot closes on or below 105 then the condition of spot closing above strike doesn’t meet hence buyer loses all the premium

For option buyer to recover the premium and get into no profit no loss condition then spot has to close at 106 which is strike + premium that is 105 + 1 = 106.

Option trading in Shares: For example lets assume price of Reliance is 3000 (Spot) and its start of month. Option buyers buys the strike of 3150 that is 5% from spot and pays premium of Rs 30 (1% of 3000) to option seller. Now if reliance moves 10% and close to 3300 then options seller will pay the difference (3300 – 3150) that is 150 to option buyer.

In case price close below 3300 then premium will go to zero and option buyer will lose the money paid to options seller. And if price closes 3030 then option seller will pay back 3030 – 3000 = 30 to option buyer meaning this is no profit no loss position for both option buyer and option seller.

Option Selling:

While option buyer pays less premium and have limited risk and chance of unlimited profit it is the probability which is against the option buyer. Option seller makes money when spot (price) settles below strike.

Now lets imagine that price is bearish on chart like a double top or break down etc. Along with this if the stock is fundamentally weak (high PE, poor profits or sales) then there is a high probability of price going down. This is the time option seller make huge contracts that too very close to the spot or even at the spot value. This is where a trader new to option selling can make money.

So assume Reliance is at 3000 and is on all time high on double top pattern. Also the sales is sluggish and sideways and profit is dropping. The under such situation option sellers will make huge contracts near spot that is 3000. Lets say option seller makes huge contracts on 3100. So if a new trader identifies share in bearish territory along with other negative conditions along with high option contract on 3100 then this trader can confidently sell contracts of 3200 or any contract above 3100. Now as majority of seller have sold contract on 3100 strike then it will be safe to sell contract over and above 3100. This is easy way to sell option contracts.

Also in bearish condition specially bearish pattern or break down of pattern or segment line then call option strikes above the break down price can be sold. Similarly under bullish conditions like pattern or break outs, put option strikes below the break out level can be sold.

Stop loss can be used on the candle on which the trade is initiated. To reduce margin option of higher strike can be bought.