Derivatives Trading Basics
by 5paisa Research Team Last Updated: 2023-07-20T15:35:35+05:30
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Introduction

Each financial transaction requires two parties- the buyer and the seller. Without the absence of even one, a transaction cannot be carried out. The same holds true for derivatives, including Options. This method can be a bit risky, especially for the ones who opt for Option Selling. The reason for it can be attributed to the fact that there is unlimited potential when trading with Selling Options.  

Unlike an option buyer who has the potential of unlimited profit with limited risk, the Option seller is in the opposite situation. An Option Seller has little profits and unlimited loss potential on the premium earned. 
 

What is Options Selling?

Buyers and sellers are the two critical components in every financial transaction. Moreover, with this comes the importance of derivatives, including Options. An Option Selling Strategy is a contract between two parties who are willing to buy or sell an asset which is decided for a specific date in the future at a predetermined price.

This Option Selling Strategy puts the buyer under no obligation to fulfill the contract. However, the seller has to honor the contract. 
In turn, the seller receives a premium on the Selling Options contract to keep this risk in consideration. 

There are two options for sellers to sell- A put option and a call option. A put option puts the seller under an obligation to buy an asset at a specific or particular price. A call option binds the seller to sell an asset at a specific price. 
 

How do Option Sellers Benefit?

Options trading benefits sellers by firstly allowing the hedging of risks. The benefit of options comes from the fact that no matter how long the price goes, your loss will be irrespective of that. Secondly, Options help in reducing your cost to hold stock. 

For instance, if you've been keeping a stock and the price for that stock has not moved at all. In this case, you can sell higher call options, thereby earning a premium and reducing the cost of holding that asset.

Thirdly, in terms of costs, the options are more efficient. Under Options Selling, when at expiry, the spot price is near the strike price, or at it, the Option expires. 

The option seller earns a premium as income, and the contract becomes worthless for the buyer. Also, when the Spot Price is below the strike price, the option sellers again earn a premium. 
 

Things to Consider While Selling Options

There are a few things to always keep in mind while Selling Options which are mentioned below. However, it would be best and of great help if you remembered that the Options Selling Strategy comes with unlimited potential for loss, and profits are finite with respect to the premium earned. 

●    In Options Selling, if the seller believes that the stock won't go below a particular level, then the option writer will end up selling a put option (it gives a holder the right to sell a stock). Similarly, if the writer abide by that the index or stock won't rise above a specific level, then he will sell a call option( it gives a holder the right to buy a stock)

●    The seller of a call option and put option has unlimited risks. For instance, if you’ve sold a stock of Tata Motors 400 call option at Rs.10, then the max profit is Rs. 10. However, if and when the stock prices go up to, say, Rs. 450, then the loss will be Rs. 40 {(450-400)- Rs. 10 premium} 

●    Selling Call Options also runs with an exposure of assignment of the Option. This risk is not involved in the European Options cases,  but in American Options. When a Selling Call Option is carried out, the stock exchange randomly assigns liability to the seller. 

●    For option sellers, it is advisable to trade with strict stop losses necessarily. Irrespective of the fact whether you've sold a put option or a call option, it is always suggested to keep stop losses. This is done to protect your capital, and the stop losses can be set with respect to the stock's market price or the price/rate of the Option. 

●    Keep in mind, when Selling Options, you are always amenable to pay margins. This is similar to paying margins similar to a  futures position. So, when selling call options, there is a margin initially that is calculated. This margin is later adjusted for the premium that is receivable. 

Furthermore, the seller of the Option is also liable to pay the margins called MTM along with any exceptional volatility margins regularly based on the conditions of the market. It is, therefore, important for these costs to be considered when you sell options. 

●    The next important thing to remember is that the selling options strategy works best when the market of the stock or the stock market has been exhibiting a clear-cut trend. 

For example, if there is a steady bullish trend, then traders will make profits by being consistent with selling put options. By churning money frequently, it is possible to better the yields on sell options when direction of the price movement is relatively more straightforward. 

●    For each option seller, there is a trade-off between In and Out the money option. This ITM, in the money option, helps in giving you a higher premium, but it comes with greater risk. 

On the other hand, the OTM, out of the money option, comes with lower risk but also lower the premium potential. In the selling Option, a seller needs to make the decision of this strike judiciously and carefully. 

●    In option selling, time value is of utmost importance. When a seller sells an option, the premium keeps on exhausting with time. This gives the seller an opportunity to exit at a profit. How? 

By buying back at lower prices or levels. Therefore, an option seller must value time. As their relationship with time is in their favor, unlike for an option buyer, where time is usually against them. 

●    A selling option is highly effective by using covered calls. An Example Of Selling Call Options can be used here for better understanding. If you buy SBI in a cash market at Rs.450 and it is now down to Rs.400, what is it that will you do? 

If you're convinced that the stock will increase in price to Rs. 500 in the next one year. Even as you hold stocks, you can simultaneously keep selling high call options. If the options expire, then the premium earned will reduce the cost of maintaining SBI.

 In the worst-case scenario, the stocks will shoot up, and you can have your hedge at a long equity position.   

●    Last but not least, it is essential to keep in mind that on a global level, 80-90 percent of the Options expire without any worth. What this means is that the seller of options stands a greater chance of making profits than a buyer of the same Option. 

This is the reason why most institutions and proprietary companies/traders are option sellers. It is often seen that retail investors are a bit more cautious with Selling Options keeping in mind the risk on return. 

As a retailer, the opportunity to earn a premium by Selling Options is always open, but the risks involved are unlimited when Selling Options. But, when stuck, then the Selling Options are an incredible and an exclusive way of helping yourself. 
 

Conclusion

An Option Selling Strategy that large traders and institutional investors employ to make profits and limit risk is a route that even retail investors can consider, as mentioned above. However, it is vital to remember that it must be done keeping in mind the adequate risk management tools that are available. 

Starting your trading journey can seem like a daunting task, but once you start, there's no looking or going back. Also, whether you're using a buying or selling option, it is an important decision. It hence must be taken seriously with thorough research in order to increase your chances of success. 
 

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Frequently Asked Questions

The Option Selling can be profitable if the seller holds the position and makes small profits every now and then. However, it is crucial for option sellers to maintain a strict stop loss to make sure that there is no considerable loss when the market moves to one side.  

The safest Option Selling Strategy is considered to be covered calls. This allows the sellers to sell a call and buy an underlying risk by reducing risks related to it. 

Buyers of an option position must be aware of the time effects and close position at a stop loss measure. Suppose a seller is entering the last month of expiry with no clarity on any significant changes. In that case, this time decay can waste a lot of your money if the prices of the underlying asset are moving substantially. 

Trading Options is extremely easy with the 5paisa app. You can start by opening a Demat account on the 5paisa app today. If you already have a Demat account on the 5paisa, you can simply login into the app, and if not, you can sign up on the app and start to sell options.