Trading Rule – “Beware the Risk of Selling Options”…

Selling options has limited upside and unlimited downsides. If you thought people must be crazy to sell options, think again! 95% of all options expire worthless. That means, in 95% of the cases, it is the seller of the option who makes money. But selling options is for the experts. If you try selling options without knowing the downside risks, it could spell disaster for you. Watch out!

WHY SELLING OPTIONS CAN BE SO DANGEROUS SO OFTEN

Back in 2004-05, Reliance Industries was stuck in a narrow range due to the corporate battle. An investor in Bengaluru was making a killing each month writing call options on the stock and taking away the premium. Then in 2005 the split happened and the stock shot through the roof. The man lost all his profits and a lot more. This is what can happen when you sell options.

For starters, when you sell a call option, you bet that the upsides are limited; and you sell a put, when you believe that downsides are limited. What you earn is the premium and what you will eventually pay is the price movement that goes against you. But in between, please remember, there is also a fund allocation in terms of initial margin and MTM margins to be done.

When you buy options your risk is limited to the premium paid. You at least know your maximum loss. But assume you sold 2 lots (1000 shares) of Tata Motors 520 call at Rs.12. You receive Rs.12,000, which is your maximum profit. But if the price of Tata Motors goes up to Rs.600, you lose Rs.68,000/- net. Now that is a rip-off for you, right? Be very cautious.

3 REASONS WHY SELLING OPTIONS CAN BE DANGEROUS

VOLATILITY CAN TRIGGER STOP LOSSES

This is a huge risk. Even if the price of the stock has not moved but volatility goes up, the price movement can go against you. Your stop losses can get triggered. Which is why, volatility is a major risk when you sell options.

DON’T FORGET THE OVERNIGHT RISK

This is a major issue for option sellers. Overnight events like rate cuts, Greek defaults and the Brazilian currency crisis can have a huge impact. More so in case of leveraged positions, where such losses can get magnified, manifold.

LIQUIDITY IN OPTIONS IS A MAJOR RISK

We all saw this in the crisis of 2004 and 2008 in equity options. If you have sold a call and price moves against you, you find it hard to exit as there are no willing sellers in a volatile market. You end up paying a liquidity premium.

“Derivatives have the potential to become weapons of mass destruction” – Warren Buffet

6 POINTS TO KEEP IN MIND WHEN YOU SELL OPTIONS

  1. Plan your margins and MTMs before getting into a position. Nothing can be sadder than having to sell your position in a fire-sale because you are not able to fund your margins. VAR is a good starting point to plan your margins. Remember that you are also going to pay higher margins for volatility.
  1. Stay light ahead of key events. This is critical because key events not only trigger price movements but also volatility in the stock. Union Budget, credit policy, results of key companies, GDP / inflation data are all key trigger points, which can alter the course of select sectors. Watch out.
  1. Fundamentals are as important as cash market investing, if not more. If you are selling calls on SBI, understand why prices cannot move up. If you’re selling puts on M&M, understand why the stock price cannot go below a point. And of course don’t forget to look at historical price pivots of the stock.
  1. Time your options selling to the extent possible. If you’re selling calls on a weak stock, sell on a day of extreme strength in the market. If you are selling puts in a strong stock, sell on a day of extreme weakness in the market. This way your risk-return trade-off is mostly favourable. And, don’t forget charts.
  1. Trend is always your friend in selling options; and always will be. If a stock is showing consistent strength, don’t show bravado and sell calls. If you want to take contrarian bets on tops and bottoms, please do so by buying calls or puts. While selling options, be as close to the trend as possible.
  1. The devil lies in the detail. Keep your eyes open. You have sold calls and there is sudden OTM call accumulation! You find institutional buying in the counter. Liquidity is suddenly vanishing from the other side! These are all indicators that market knows a thing more than you. Just exit your position!

SELLING OPTIONS IS SURELY NOT EVERYBODY’S CUP OF TEA

The whole problem in selling options as a strategy is that inflows come in a trickle and outflows can happen in bulk. This is more so, if you sell options without understanding the nuances of the game. But there are situations when you can use this strategy profitably. One such case is if you are holding on to a stock and selling call options, you are covered on your option risk. Also you earn money on idle stock holdings. Sounds good, eh!

Historically, option selling backfires after going in your favour for a very long time. Take the case of Nick Leeson who rode his luck selling strangles on the Nikkei for too long and was finally done in by the Kobe earthquake. Or the hundreds of traders who consistently made a killing selling put options on oil in 2007, before being done by the crash in oil. These are the kind of typical black swan events which can result in your option position backfiring.

TAKEAWAYS FROM THE “OPTION SELLING” DEBATE

Let me conclude with an anecdote from the past. Many years ago I had advised an investor to sell an OTM put on SBI, as the downsides appeared limited. You can imagine my shock, when I was told nonchalantly that he had sold a call, instead of a put, as the premiums were higher. He was lucky to have got away with the gaffe, but you may not always be that lucky.

Normally those who sell options get beaten by two factors. First is their inability to appreciate and manage overnight risk. Second, of course, is their inability to handle volatility. At the end of the day, your primary goal in the equities business is to conserve your capital value. You surely do not want a bad option selling decision to wipe you out. Selling calls and puts is not for the casual investor. Think about it thoroughly, before selling a call or put option next time. A right decision can be profitably; but a wrong decision can be disastrous.

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