Investing in options – Options writing

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Options writing

Investing in options

Investing in options – Options writing

Question: What is writing options all about?

Answer: A seller of Options is generally called as a Writer – in the initial days of Option Trading before the advent of computers, Option sellers wrote out a Contract and gave it to the Option buyers.  Thus, the term Writers was coined and has stayed.

The writer of Options earns a limited profit (the premium), but can incur unlimited losses.

Question: What view does the Option writer have?

Answer: The writer of the Call Option is generally bearish while the writer of the Put Option is generally bullish.

Question: What is the payoff the Option writer faces?

Answer: Suppose you write a Satyam Rs. 280 call and earn a premium of Rs. 19. This is your income, which you will receive from your broker on the next day. You are bearish about Satyam. Suppose Satyam closes at Rs. 290, you will pay the difference of Rs. 10 (between market price and strike price) to the exchange. Your net profit will be Rs. 9.

If Satyam closes at Rs. 280 or below Rs. 280, you will be happy as your entire premium remains with you.

You should be careful to understand that if Satyam really moves up (say Rs. 330), you will have to pay the difference of Rs. 50, thus suffering a net loss of Rs. 31. Losses can be unlimited as Satyam can go to any level.

Question: What happens in case of Puts?

Answer: As a Put writer, you will again receive a premium income. Suppose you sell a Satyam Rs. 300 Put for a premium of Rs. 31, that is your income, which will be received on the  next day. You are bullish about Satyam in this case.

If Satyam closes at Rs. 285, you will have to pay the difference of Rs. 15 (between strike price and market price) to the exchange. If Satyam closes at Rs. 300 or above Rs. 300, then you can retain your entire income of Rs. 31.

Again, you are exposed to severe losses. For example, if Satyam moves down to Rs. 230, you will have to pay a difference of Rs. 70, resulting in a Net Loss of Rs. 39.

Question: So if Option writing is so risky, why should anybody write Options?

Answer: There could be several aspects to this strategy. First, you might be sure of your view and hence do not mind generating an income from it. Secondly, unlimited losses might not actually happen in practice. For example, if you have sold the Satyam 280 Call (you are bearish) for Rs. 19 and Satyam actually starts moving up. You will become nervous. So what will you do?

You will buy back the Satyam call. It could have become more expensive (say Rs. 25). So, what you sold for Rs. 19, you will buy back at Rs. 25, making a loss of Rs. 6. That is not unlimited in practice.

Thirdly, most Option writers are more sophisticated players and will cover their unlimited risks by some other position. For example, they might sell one call and buy another call (bull or bear spread). They might sell a call and buy a future. They might sell a call and might the underlying shares. There could be more complex strategies.

Option Writing however requires:

  • a higher degree of understanding,
  • sophistication,
  • risk management ability
  • a very active presence in the market regularly.

Question: Do you earn more in Option Buying or Selling?

Answer: This question is really difficult to answer. It will be correct to say that Option Buyers who have unlimited profits do not always make these unlimited profits and Option Writers who face unlimited losses do not always make unlimited losses.

That stated, the frequency of profits and losses by each category of players is difficult to know or even judge. It is also wrong to say that individual investors will always buy calls and brokers/institutions would be writing calls all the time.

Question: What kind of margins are applicable on Options?

Answer: Option writers need to understand impact of margins clearly. Option buyers need to merely pay the Premium. No margins are applicable on Option buying. But Option writers face unlimited losses. Hence, the exchanges will levy margins on them. The Premium paid by Option buyers will be received in cash by Option writers. This settlement is effected on t + 1 basis. Thus, if you have written a Satyam Option for Rs 20 each, you will receive Rs 24,000 cash next day (1,200 x 20).

However, the exchange will ask you to maintain a Margin for the possible losses that you might incur. The margining system currently adopted by India is a sophisticated mechanism based on SPAN software, a program developed by Chicago Mercantile Exchange. The program creates 16 imaginary scenarios for each option position (varying levels of price movements and volatility movements are considered) and the maximum possible loss that you might incur is taken as the margin amount to be paid by you.

In a later article, we will discuss in more detail, the intricate calculations of SPAN.

Question: In what form is the margin payable?

Answer: The margin can be paid to your broker in cash or cash equivalents or equity securities. Cash equivalents comprise Government securities, Debt securities, Bank guarantees, Fixed deposits and Treasury bills. If the amount of margin falls short due to the SPAN demand being higher, the balance margin can also be brought in by you in any of these forms.

For ease of calculation, you, as an Option writer should be prepared to bring in margins of around 20% to 40% of the Notional Contract Value.

Question: What is Notional Contract Value?

Answer: If we use our Satyam example, a Satyam 300 Put is sold for Rs 31. The lot size is 1,200 shares. The Notional Contract Value is Rs 331 x 1,200 = Rs 3,97,200. The margins are calculated on this amount.

Question: Are Margins steep?

Answer: No, the margins are levied on a scientific basis and if the volatility of the underlying is high, the margins will also turn out to be high. It is important to have a clear and scientific methodology for margining, as exchanges and the market as a whole will be able to functoin smoothly only if the margining system is proper. The US has experimented with various systems since 1973 before accepting the SPAN system as a sophisticated and scientific system. We are lucky in India not to go through all their pains and get a ready made system in the first place.

Question: What should I consider as the cost of margins?

Answer: In my opinion, if you hand over your Fixed Deposits to your broker, this will only be marked as a lien in your account. You will continue to hold the Fixed Deposit in your name and will continue to earn interest income therefrom. In such a situation, there is no real cost your incur.

If you obtain a Bank Guarantee, the only cost you really incur is the bank commission on the guarantee. In a similar manner, if you mark a pledge on equity securities, your effective cost is zero. Thus, though margins may be high, your effective cost is negligible. Obviously, in the event of default, your cost will be high, but that is not attributable to the margining system.

Question: What is the brokerage I will pay on derivative transactions?

Answer: As per current market practice, the brokerage charged varies between 5 paise per Rs 100 to 10 paise per Rs 100. An average derivative transaction is around Rs 2 lakhs. Accordingly, the brokerage per transaction comes to around Rs 100 to Rs 200. The percentage should be applied on the Notional Contract Value which was defined earlier in this article.

In the next article, we will discuss the intricacies of Option Strategies.

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