It is of utmost importance to know the intrinsic difference between ‘Buying of options‘ and ‘Selling of options‘.
Buying an option
When you buy a Call option or buy a Put option, your commitment to the contract is limited to the premium you pay. For example, if A buys a Call option of Nifty for Rs 50/-, and Nifty falls, the premium on the option will start falling in value , thereby resulting in a loss to A. Even if the Nifty falls by 100, the premium on the option cannot go below zero on to the negative side. Therefore, the loss incurred by A cannot be more than Rs 50/- (i.e.the initial premium paid). But if Nifty rises, the profits can be unlimited - as much as Nifty rises. For example, this month (June) we have seen Nifty Call 4500 rising from about Rs.40/- to about Rs.145/- in just about 7-10 days’ time.
Similarly when you buy a Put option, your commitment is limited to the initial premium paid. Taking a similar example, if A buys a Put option of Nifty for Rs 50/-, and Nifty rises, the value of the Put can decrease to zero but not into negative territory. The maximum loss incurred by A will be Rs 50/- (i.e.the initial premium paid). But if Nifty falls significantly, the profits can be unlimited - proportionately just as much as Nifty rises.
Selling an option
a) You can sell an option you have already bought to square up at a profit or loss. Your contract ends with no further liability.
b) You can be an initial seller of options. This is called short-selling or specifically as OPTION WRITING. This is almost like short-selling in intraday cash share trade, with the difference that you are not necessarily required to square off the transaction (by buying the Call back) during the same trading session. In fact you can square off the transaction any time up to the expiry date - depending upon as to when you’re able to realise your optimum profit.
What are the liabilities of an option writer ?
The option writer who sells Calls or Puts without having initially bought them faces a possibility of unlimited gains or unlimited loss depending on which way the index or scrip moves. When he sells an option, (Call or Put), the premium collected gets credited into his account. But, he has a responsibility to compensate the buyer of the option against any movement in favor of the buyer. For example, if he sells a Call option to A, and if the call premium moves up along with upward movement of the index or scrip, the benefit to A will be provided from the premium collected by the Option Writer. If he sells a Put option to B, and if the call premium moves up along with downward movement of the index or scrip, the benefit to B will be provided from the premium collected by the Option Writer. His liability exists till he squares up his position by buying back the Call or the Put.
To protect the buyer against default by the Option Writer, the latter has to pay a deposit to the Exchange for each option sold. This amounts to about 10% of the total value of the option (not just the premium, but the strike value x units per lot) for Nifty (about Rs 20000/- presently), but is considerably higher for individual scrips. The actual percentage is calculated depending on volatility and open interest position in the derivative. This may vary from day to day or week to week. The deposit is returned to the Option Writer once he has squared up his option (after adjustments for any loss or gain).
How does an option writer make money ?
The gains follow this formula : Selling premium minus buy back premium x units per lot x number of options.
This could be possible in any of the following situations :
a) By buying back if the option premium falls due to volatility of the scrip.b) If the scrip price remains stagnant, the option writer would gain by the inevitable time decay (see under Terminology category) that occurs as the expiry date approaches.
Usually option writers concentrate on large volumes and low profits per option, thereby ensuring consistent profits. Option writing using time-decay is a method of generating a monthly income from the markets as against investing or speculating - that is dependent only on scrip movements.