Basics of Options Shorting/Writing

Option writing/shorting is the act of selling either calls or puts first, hoping that the value goes to zero or buy it back at a lower price to earn a profit.

Trading in index options has been surging over the last few years, accounting for almost 75% of the total derivative market turnover on NSE in 2012-13. Most retail traders usually buy options, i.e., buy calls if the bet is that the market will go up or buy puts if going down. The idea behind this post is to explain the basics on option writing/shorting, and  how including them in trading can improve the odds of winning.

We use  the words option writing/shorting and not option selling, to signify that the options were sold first before being bought. Selling options is used when exiting options that were already bought.

Why Short/Write Options

Here is some food for thought, between 70 to 95% of all options usually expire worthless. What this means is that by buying an option (calls or puts) the odds of losing are significantly more. Now the question is if options buyers are inherently taking a higher risk, who is on the other side of the trade with better odds of winning? The answer is “Option Writers”.  Let me explain with a basic introduction to what comprises option premium, different types of options, open interest and an example showing how most options expire worthless.

Option Premium

Option premium, the value of calls or puts that you see on your trading screens has two components, Intrinsic value, and time value.

Premium = Intrinsic Value + Time value 

Intrinsic value

Intrinsic value is how much the option is in the money, or simply how much you would get if the options were to expire right now.

1. If Nifty is at 6100, Intrinsic value of 6000 Nifty calls is 100 (6100 – 6000) which is how much you would get if the option expired right now.
2. If Nifty is at 6100, Intrinsic value of 6200 Nifty calls is 0, since it is out of the money which is how much you would get if the option expired right now.
3. Similarly if Nifty is at 5900, Intrinsic value of 6000 puts is 100 and 5800 puts is 0.

Time value

Time value is the portion of premium which is over and above the intrinsic value of an option, i.e., Time Value = Premium – Intrinsic value

Say if Nifty is at 6240,

1.  Nifty 6200 call is at Rs 100. This premium of Rs 100 = Rs 40 (Intrinsic value)+ Rs 60 (Time value)
2. Nifty 6300 call is at Rs 40. This premium of Rs 40 = Rs 0 (Intrinsic value) + Rs 40 (Time Value)
3. Nifty 6200 put is at Rs 60, This premium of Rs 60 = Rs 0 (Intrinsic value) + Rs 60 (Time Value)
4. Nifty 6300 put is at Rs 140, This premium of Rs 140 = Rs 60 (Intrinsic value) + Rs 80 (Time Value)

Different types of options

• ITM (In the money), all options which have some intrinsic value. So if Nifty is at 6240, 6100 calls, 6300 puts, 6400 puts, etc. are ITM.
• OTM (Out of the money), all options which have no intrinsic value and only time value. So if Nifty is at 6240, 6300 calls, 6400 calls, 6100 puts, etc. are OTM.
• ATM (At the money), all options with strike price very close to the market price. So if Nifty is at 6210, 6200 calls and 6200 puts are ATM.

Open Interest (OI)

The total number of open contracts for any option is called its Open Interest. So if  Nifty 6200 Jan 2014 calls have OI of 30 lakh, that means all buyers of 6200 calls together hold 30 lakh contracts sold to them by option writers.

Example

Here is  OI data collected  for 8th Jan 2014 from the NSE website for both calls and puts for 9 most active strike prices on Nifty.

Nifty OI data for 8th Jan 2014

In the example above if Nifty were to expire today at 6200, the total options that would expire worthless would be : 39295000 (15102150 + 3150000 + 4235750 + 16807100) which is around 83% of the total OI of all calls and puts combined.

Yes, an option buyer can take quick intraday trades for a profit, or be on the right side of the market and have the potential of making unlimited profits, but the odds of winning are always in favor of an option writer who benefits with majority of options expiring worthless.

The underlying reason for this is because of the time value component of the option premium (Premium = Intrinsic Value + Time Value). A buyer of an option is continuously fighting time because if the trade doesn’t go in his favor immediately, the time to expiry keeps reducing(time value), and hence the premium itself. An option writer on the other side has time as his advantage, once in a trade as long as the market (intrinsic value) doesn’t move against him the time value keeps reducing, increasing his odds of winning over an option buyer.

Option Writing – Risks

An option buyer has limited risk and unlimited profit potential, so if 1 lot of 6300 Nifty call was bought at Rs 100, the maximum loss on this trade is the Rs 5000 (Rs 100 x 50), and if Nifty went to 7300 the call would make a profit of Rs 45,000.

An option writer has unlimited risk and limited profit potential.

When you write an option, say 1 lot of 6300 calls at Rs 100, Rs 5000 (Rs 100 x 50) which is the premium paid by the buyer is credited to your trading account and this Rs 100 on the premium is your maximum profit potential.  After taking this trade if

1. Nifty is 6200 on expiry, value of 6300 calls on expiry is 0, and you get to keep the entire Rs 5000.
2. Nifty is 6300 on expiry, value of 6300 calls is still 0, and you get to keep the entire Rs 5000.
3. Nifty is 6350 on expiry, value of 6300 calls would be 50, you have to give back Rs 2500( Rs 50 x 50) on expiry, but still earning you a profit of Rs 2500.
4. Nifty is 6400 on expiry, value of 6300 calls would be 100, you would have to give the entire Rs 5000, no profit no loss.
5. Nifty is 6500 on expiry, Value of 6300 calls would be 200, you would have to give back Rs 10,000 whereas you had received only Rs 5000, causing you a net loss of Rs 5000.
6. Nifty is 7500 on expiry, Value of 6300 calls would be 1200, you would have to give back Rs 60,000 whereas you had received only Rs 5000, a net loss of Rs 55000.

Since the potential losses are unlimited, it is best as a beginner option writer to be conservative, and allocate only a small portion of your trading capital when starting off.

Option Writing – Margins

Since the risk is unlimited for an option writer, the exchange blocks margin and similar to futures is marked to market at the end of every day. So to buy an option at Rs 100, you need to have only Rs 5000 ( Rs 100 x 50), but to write an option you will need around Rs 25,000 which is marked to market daily, which means that if there is a loss you are asked to bring in those funds to your trading account by end of the day.

Option writing margin requirement varies for every contract, and as on today Zerodha is the only brokerage in India to offer a web based SPAN tool that lets you calculate this.

Example

You have a bearish view of the market and Nifty is presently at 6172. You decide to write/short 6200 Jan 2014 calls at 90 expecting to profit if the value comes down below 90 on the premium.

Check the SPAN calculator for the margin required as shown below:

Option Margin calculation

This is just an introduction for traders looking to start off on option writing, exercise caution, and once you are clear with the concepts look at combining short options with stocks, futures, or other long options, to create positions that can increase the odds of winning while trading considerably.

Happy Trading,