In case you have read my earlier piece, and your curiosity has been whetted as to which ‘damn fool’ would hand over a right and take on an obligation for a paltry premium, here’s the answer.
The person that does this is an option seller (or writer). He takes on an obligation without any right. Yes, he gets the premium. Is that enough for taking such a big risk?
Let’s say you hold 1,000 shares of a company currently trading at Rs700. You have been holding the shares for some months now and you are in profit because your average buying cost is Rs500. You don’t mind holding the shares for some more time, but you don’t expect much increase in the price in the next few months.
You can take up a ‘covered call’ position, which means that you sell a call option on 300 shares at a strike price of Rs750, with an expiry date of three months from now. Let’s say you get a premium of Rs25 per share, i.e. Rs7,500. Now your situations, in some future scenarios are:
- If the price remains flat, or goes up to Rs750 at most, three months from now the option will not be exercised. You will still have your 1,000 shares, plus Rs7,500. In fact, if the share climbs to exactly Rs750, you will get an appreciation of Rs50,000 on your 1,000 shares, and have the Rs7,500 too.
- If the price goes to Rs800 the option buyer will exercise his call option. You will have to sell 300 shares at Rs750 and thus ‘lose’ Rs15,000 (because if you hadn’t sold the Option you could have sold the 300 shares in the market at Rs800 instead of Rs750). But, your remaining 700 shares would have appreciated by Rs70,000 (vis-à-vis today’s price of Rs700) and you would still have the Rs7,500 premium money.
- If the share falls, you would have the same position on your 1,000 shares as you would if you hadn’t done the covered call, but you will have Rs 7,500 as a consolation prize.
There is one more twist to this game.
The value of an option slowly decreases with time as the expiry date approaches. There is not much value in an option that is close to expiry because the chance of it being worth exercising becomes less and less as the remaining time decreases, and hence the premium on the option decreases with time, quite rapidly as you approach the expiry.
So, after having sold the call at a premium of Rs25, you should see the premium reduce steadily. You may find it possible to close out your position on the call by buying the same call at a lower premium, and you will be back to your original position with a profit, the difference between the premium you got and the premium you paid.
Please note that I have described a ‘covered call’. Why ‘covered’? Because your obligation, or exposure, under the call option is covered by the shares you already hold.
An option that is sold without the seller having adequate cover is called a ‘naked’ option. This can be highly dangerous because there is no limit to your loss if the price goes in a steep climb or a free fall and the option is exercised.
A reputed pharma company nearly went bust because it was (allegedly) persuaded, by some foreign banks, into selling naked options with the allure of ‘phokat ka paisa’ from the premium. The resultant dispute became messy, but it was ultimately settled and the company survived.
As you can see, an option seller doesn’t want the price to move enough for the option to be exercised. He hopes that the price will move in his favour, remain steady, or (at worst) move slowly against him to a point just below the strike price. In the process he earns the premium. All the while he remains protected by his ‘cover’.
In a sense, selling an option is like running a single, not hitting a sixer, in a T20 match. It seems slow, but the singles add up, as do the premiums over time. That is why the saying goes “options are meant to be sold”.
Going back to the start for a moment – you can protect your position of having 1,000 shares by simply buying a put option at Rs650, for example. Even if the shares fall, you will get Rs650 at least. Of course, you will have to pay the premium on the option. But this simple method puts a ‘stop loss’ in place.
All along I have been saying: premium, premium, premium. About time you get to ask - what determines the premium?
There are very complex mathematical models, such as the Black-Scholes model, which I, frankly, have never even tried to understand. I look at it like I look at a computer program – I don’t know how it works, but I like to use the result. Suffice it to say that the premium amount depends on several factors, such as:
- The strike price. If you want a call option that lets you buy shares at Rs600 when the market price is Rs500, you will pay less than a call option at Rs550.
- The duration of the option. A three-month option will cost more than a one-month one at the same strike price.
- Volatility. If the price of the underlying stock (or oil or gold) has been fairly steady recently, options will cost less. If the price has been volatile, swinging up and down unpredictably, the price will be more.
There, I have made my narrative as simple as I could, in the hope that your interest may have risen after getting an insight into what options are all about and what you can do with them.
There are many other ways to use options to play the market, or to protect your current holdings from a fall in price. The internet has tons of stuff on options if you are really interested. A good starting point is the tab ‘derivatives’ in the BSE home page.
Happy reading, folks!!
(Deserting engineering after a year in a factory, Amitabha Banerjee did an MBA in the US and returned to India. Choosing work-to-live over live-to-work, he joined banking and worked for various banks in India and the Middle East. Post retirement, he returned to his hometown Kolkata and is now spending his golden years travelling the world (until Covid, that is), playing bridge, befriending Netflix & Prime Video and writing in his wife’s travel blog.)