7 mistakes to avoid while options selling
Selling options is a limited return but unlimited risk game. For instance, if you sell a call option of strike Rs100 at Rs10 premium and if the price goes to Rs180, then any price beyond Rs110 is the loss to the option seller. That is why, selling options is not for retail investors. Normally option selling is done by proprietary desks of brokers, FPIs and large institutions.
The option seller always takes a contrary view. The focus is not on what will happen, but what will not happen. The seller of the call options, expects the price of the stock will not go above the strike price. The seller of the put options expects that the price of the stock will not go below the strike price. Buying options is more an affirmative decision.
Since losses are unlimited in selling options (call and puts), it is always advisable to sell options only with strict stop loss. That is a kind of protection in the event of the volatility going against you. The good thing in selling options is that, in the case of OTM and ATM options, time actually works in favour of the seller of the option, rather than the buyer.
Buying options only attracts premium margins. However, selling options attracts upfront SPAN margins and daily mark to market (MTM) margins. That is because, like in futures trading, even in options selling, the downside risk can be unlimited for the seller of the call and put options.
Selling options can make money when the trend in the market is clear. For instance in bullish market conditions, option sellers make profits by consistently selling lower put options. Similarly, in falling markets, they consistently sell higher calls. The focus is on rapid churning of capital to increase ROI in selling options.
When you sell options, be clear about the difference between a naked option sale and a covered option sale. The former is risky, the latter is not risky. For instance, if you are holding the stock of SBI and sell higher SBI call options, risk is limited. If the price goes up, then whatever you lose on the call option sold will be compensated by your holding in SBI. The only thing to ensure is to retain the covered position. Don’t sell the stock of SBI and hold the sell call position. Then it becomes a risky naked position.
Finally, let me share an interesting piece of statistics here. Nearly 80% to 85% of options globally expire worthless. As a seller of options, the probability of making profits is much higher than in buying options. It is due to this higher probability of profit that institutions and proprietary traders prefer to sell options. However, as a retail investors, you must be cautious about the risk.
Selling options is not everyone’s cup of tea. However, basic checks and balances can go a long way in reducing your risk.
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