Selling Call Options – Option Strategies Part 2

Both the buyer of the option and the writer (seller) of the option are two sides of the same coin. Just the opinion of both about the market and the expectations of both are different. Here you should remember one thing that the P&L of the seller of the option and P&L of the buyer of the option are exactly the opposite. For example, if the seller of the option is making a profit of ₹70, it means that the buyer of the option is incurring a loss of ₹70.

• If the risk of the option buyer is limited (as much as the premium he has paid) then the profit of the option seller is also limited (as much as the premium he has received)
• If the option buyer’s profit is unlimited, then the option seller’s risk is unlimited.
• The break-even point is the price from which the option buyer starts making money. This is exactly where the option seller starts losing money.
• If the buyer of the option is making a profit of ₹ X, it means that the seller of the option is making a loss of ₹ X.
• If the seller of the option is making a loss of ₹ X, it means that the buyer of the option is making a profit of ₹ X.
• If the option buyer is of the opinion that the price will go up in the market, then the option seller will have the opposite opinion and feel that the price will go down in the market.

To understand these things better, it is important to look at call options from the seller’s point of view and that is why we will focus on it in this chapter.

But before proceeding further in this chapter, I want to tell you one important thing, there is a lot of similarity between the P&L of option seller and option buyer, so many times in this chapter you will feel that we are talking about the same things. which have been described in the previous chapter. It is possible that in such a situation you will feel that we are repeating things and you can move on to the next chapter. I advise you not to do this. Look carefully at the smallest difference between the seller’s and the buyer’s P&L and the impact it can have.

Call option seller and his thinking

Recall once again the example of Ajay and Venu that we discussed in the first chapter. We saw that there are 3 possible situations that could happen in this agreement.

1. Land price may go above ₹500000 (means a better position for option buyer)
2. Price may remain stable at ₹500000 (better position for the seller of the option)
3. Land price may go below ₹500000 (means a better position for the seller of options)

You can see that the percentage of probabilities is not in favor of the buyer of the option. Out of three chances, only one is in his favor. This means that 2 out of 3 possibilities are going to benefit the option sellers. This is the reason that encourages people to sell options. Apart from being on the side of probabilities figures, if the option seller has a good understanding of the market, his chances of making a profit are greatly increased.

Remember, I’m only talking about probabilities in terms of numbers here. I am not saying that the option seller will always make money.

Let us once again look at the Bajaj Auto example that we discussed in the previous chapter. This time let’s look at it from the point of view of the option seller and try to understand how the situation is turning out for him. Let’s look at the same chart again.

• The stock is badly beaten. This means that there is a bearish atmosphere among the people regarding this stock.
• Due to the stock being so beaten up, many people would be trapped by making long positions in the stock.
• In such a situation, any increase in the price of the stock will be seen by people as an opportunity to exit from this stock.
• Because of this, there is little scope for a sharp increase in the stock price.
• If there is less scope for the stock price to rise in the market, then selling the call option of the Bajaj Auto stock and taking the premium can be a good opportunity.

So, with this thought in mind, the seller of the option sells the option. The most important thing here is that he is confident that the price of Bajaj Auto will not go up yet and hence selling the option and taking the premium is a good strategy.

As I said in the previous chapter, knowing the right strike price is the most important part of options trading. We will discuss this in detail as we move forward in this module. For now, just assume that the seller of the option has decided to sell the option of Bajaj Auto at the strike price of 2050 and for this, he has charged a premium of ₹ 6.35. Let us once again look at the option chain given below-

Like in the previous chapter, once again we try to understand the P&L of the option seller and through this draw some general points/generalizations which can tell something about selling call options. What we learned about the intrinsic value of options in the previous chapter will apply here as well.

Serial No.	Possible values of spot	Premium Received	Intrinsic Value (IV)	P&L (Premium – IV)
01	1990	+ 6.35	1990 – 2050 = 0	= 6.35 – 0 = + 6.35
02	2000	+ 6.35	2000 – 2050 = 0	= 6.35 – 0 = + 6.35
03	2010	+ 6.35	2010 – 2050 = 0	= 6.35 – 0 = + 6.35
04	2020	+ 6.35	2020 – 2050 = 0	= 6.35 – 0 = + 6.35
05	2030	+ 6.35	2030 – 2050 = 0	= 6.35 – 0 = + 6.35
06	2040	+ 6.35	2040 – 2050 = 0	= 6.35 – 0 = + 6.35
07	2050	+ 6.35	2050 – 2050 = 0	= 6.35 – 0 = + 6.35
08	2060	+ 6.35	2060 – 2050 = 10	= 6.35 – 10 = – 3.65
09	2070	+ 6.35	2070 – 2050 = 20	= 6.35 – 20 = – 13.65
10	2080	+ 6.35	2080 – 2050 = 30	= 6.35 – 30 = – 23.65
11	2090	+ 6.35	2090 – 2050 = 40	= 6.35 – 40 = – 33.65
12	2100	+ 6.35	2100 – 2050 = 50	= 6.35 – 50 = – 43.65

 

Before we discuss this chart, keep some things in mind-

• The addition/plus (+) sign in the premium column indicates that money is coming into the option writer’s account.
• The intrinsic value (at expiry) of the option remains the same whether for the seller of the call option or the buyer of the call option.
• Net P&L for call option writers is calculated in a slightly different way.

The reason for this change is that-

The seller of the option who sells the option receives a premium (say a premium of Rs.6.35). Meaning if he has got a premium of ₹6.35 and has incurred a loss of ₹5, it means that he is still sitting on a profit of ₹1.35. That is, the option seller’s loss starts when he loses the entire premium amount. The loss after losing the premium is its actual loss. Therefore, in the calculation of his P&L will be, ‘Premium – Intrinsic Value.

The same thing can be applied to the buyer of the option. Since the buyer of the option pays the premium, he must first earn his premium back, only then his profit will start. Whatever he earns after getting the premium amount back is his actual profit.

The above table will look familiar to you. Based on this table we can now draw some general things (remember that the strike price is 2050)

As long as the Bajaj Auto stock stays below the 2050 strike price, the option seller will make money. Meaning he will get a chance to keep the full payment of ₹ 6.35 with him. Keep in mind that his profit will remain constant at ₹6.35 paise and not more than that.

Generalization 1 – The maximum profit to the writer of the call option will be as much as the premium he has received. Yes, the spot price needs to be below the strike price to earn this profit.

If the price of Bajaj Auto starts moving above the strike price, then the loss of the option writer can increase.

Generalization 2 – The call option writer incurs a loss when the spot price moves above the strike price. The higher the spot price goes above the strike price, the bigger will be the call writer’s loss.

It is clear from the above two generalizations that the profit of the option seller is limited but the loss can be unlimited.

Now on the basis of these, we try to make P&L of the call option seller

P&L = Premium – Max [0, (Spot Price – Strike Price)]

Based on this formula, P&L is calculated for certain spot prices at expiry

2023
2072
2055

The calculation will be like this-

@2023

= 6.35 – Max [0, (2023 – 2050)]

= 6.35 – Max [0, -27]

= 6.35 – 0

= 6.35

 

This figure is correct according to normalization. (Profit is limited to premium)

@2072

= 6.35 – Max [0, (2072 – 2050)]

= 6.35 – 22

= -15.65

Here also the answer is the same as in Normalization 2. (The call option writer will incur a loss when the spot price moves above the strike price)

@2055

= 6.35 – Max [0, (2055 – 2050)]

= 6.35 – Max [0, +5]

= 6.35 – 5

= 1.35

Although the spot price is above the strike, the call writer is still showing some profit. This is the opposite of Normalization 2. You have come to know by now that this is due to the principle of break-even point, which we have understood in the previous chapter.

Now let’s take a closer look at this and try to find out what is the price near the strike price where the call option writer starts incurring losses.

No.	Expected Spot Price	Recieved Premium	Intrinsic Value (IV)	P&L (Premium – IV)
01	2050	+ 6.35	2050 – 2050 = 0	= 6.35 – 0 = 6.35
02	2051	+ 6.35	2051 – 2050 = 1	= 6.35 – 1 = 5.35
03	2052	+ 6.35	2052 – 2050 = 2	= 6.35 – 2 = 4.35
04	2053	+ 6.35	2053 – 2050 = 3	= 6.35 – 3 = 3.35
05	2054	+ 6.35	2054 – 2050 = 4	= 6.35 – 4 = 2.35
06	2055	+ 6.35	2055 – 2050 = 5	= 6.35 – 5 = 1.35
07	2056	+ 6.35	2056 – 2050 = 6	= 6.35 – 6 = 0.35
08	2057	+ 6.35	2057 – 2050 = 7	= 6.35 – 7 = – 0.65
09	2058	+ 6.35	2058 – 2050 = 8	= 6.35 – 8 = – 1.65
10	2059	+ 6.35	2059 – 2050 = 9	= 6.35 – 9 = – 2.65

Clearly, even after the spot price moves above the strike, the option writer remains profitable as long as the spot price does not exceed the strike + premium. This price is called Break down point and after that, the seller of the option starts incurring losses.

Break Down Point = Strike Price + Premium Received for Call Option Seller

In the example with Bajaj Auto

= 2050 +6.35

=2056.35

So the break-even point of the buyer of the call option becomes the breakdown point of the seller of the call option.

Call Option Seller’s Pay-Off

As we have seen time and again in this chapter, there is a lot of similarity between the writer of a call option and the buyer of a call option. If we look at the P&L graph of the option seller, we see this very clearly-

You can see that the P&L pay-off for the seller of the call option is mirrored by the P&L pay-off for the buyer of the call option. The things that emerge from this graph are similar to what we have discussed so far in this chapter.

1. As long as the price remains below the strike price i.e. 2050, the profit remains 6.35.
2. When the price remains in the range of 2050 to 2056.35 (Break Down Point) then the profits keep on decreasing gradually.
3. There is neither profit nor loss on reaching 2056.35.
4. After the price of 2056.35, the seller of the call option starts making a loss. As you can see in the graph, as the price goes up, the loss increases exponentially.

A few things related to margin

Now let’s look closely at the risk associated with selling options and buying options once. The buyer of the option does not have any risk, he only has to pay a premium to the seller. In exchange for this premium, he gets the right to buy the underlying on any subsequent day at a fixed price. Thus, his risk is only as much as the premium he has paid.

But when we look at the risk of the option seller, we know that his risk is unlimited. If the underlying price moves up in the spot, then the option seller’s loss also increases exponentially with the same. But if we look at it from the point of view of the stock market or stock exchange, can he find any other way to reduce the risk of the option seller? What if the risk or loss of the option seller becomes so high that he decides to default instead of taking the loss?

It is certain that no stock exchange will allow a situation where the option seller makes a huge default. That is why it is necessary that the seller of the option deposits a certain amount with the exchange as margin money. The margin for the option seller is the same as in a futures contract.

In the snapshot below of a Margin Calculator let us see what is the margin of Bajaj Auto Futures and Bajaj Auto Call Option Agreement with a strike price of 2050 both with expiry 30 April 2015.

And the margin for selling the 2050 call option is-

As you can see the margin requirement for option writing i.e. selling option and futures agreement is almost equal. But there is a small difference also. We will discuss this difference in detail later. Just remember that the margin requirement is almost the same and the amount is almost the same.

All things together / Now let’s see all things together

I hope that after the last 4 chapters, you now know and understand a lot about selling options and buying options. By the way, it is a bit more difficult to understand the option as compared to other subjects. That is why whenever we get a chance we should try to repeat what we have learned so far. That’s why once again let’s look at the special things that are associated with buying and selling options.

Things to know about buying options

• You should buy an option only when you expect the price of the underlying to go up. If the spot price reaches above your strike price on the day of expiry, then only you will benefit from this agreement.
• Buying an option is called a long on-call option – ‘Long on a call option’ or simply a long call.
• To buy an option, you have to pay a premium to the option writer.
• The risk of a call option buyer is very limited (the premium he has paid) but his profit can be unlimited.
• The break-even point is the price at which the buyer of the call option is neither making profit nor losing.
• P&L = Max[0,(Spot Price – Strike Price)] – Premium Paid.
• Break-Even Point = Strike Price + Premium Paid

Important things to know about selling options

• Selling an option (also called option writing) should be done only if you expect the price of the underlying to remain below the strike price by the day of expiry.
• Selling an option is called Shorting a call option – ‘Shorting a call option’ or sometimes just a short call.
• When you sell the option, you get an amount as a premium.
• The profit of the option seller is limited – the amount of premium he has received, but his loss can be unlimited.
• The breakdown point is the price at which the option seller is neither profiting nor losing, having lost all of his premium by the time he reaches the breakdown price.
• Since the short position of the option carries unlimited risk, the seller of the option has to pay margin money to the exchange.
• The margin money of an option is similar to the margin money of a futures contract.

Some more important things

1. When you are bullish on a stock, you buy that stock in the spot market or in the futures market or buy a call option of that stock.
2. When you are bearish on a stock, you can sell it in the spot, sell it in the futures or short it in the options market.
3. The intrinsic value of a call option is not affected by whether you are buying or selling the call option.
4. But if it is a put option instead of a call option, then the intrinsic value changes.
5. The net P&L of a call option varies depending on whether you are a seller or a buyer.
6. In the last four chapters, we have looked at the P&L only till the day of expiry so that you can understand these principles properly.
7. Most of the trading of options is based on the change in margin, for example, if I bought an option of Bajaj Auto with strike price of 2050 at a premium of ₹6.35 and by the end of the afternoon, its premium may have increased to ₹9, then I would call it I can book my profit by selling.
8. The premium of any option changes continuously every minute. Many things are working behind this change, which we will understand in the next chapter.
9. The short form of Call Option is CE, then the 2050 Call Option of Bajaj Auto is written as Bajaj Auto 2050CE. Here CE stands for European Call Option.

European Vs American Option

When options trading was started in India, there were 2 options– American option and European option. All types of index options such as Nifty options or Bank Nifty options were based on European options, while options on individual stocks were based on American options. The difference between the two was based on the way the option was exercised.

European Option – In a European option, the buyer had to regularly wait till the expiry of the option to exercise his option. The settlement was based on the spot price of the underlying on the day of expiry. This means that if the Bajaj Auto call option is bought at the strike price of 2050, the buyer will make a profit only if the Bajaj Auto stock moves above the strike price on the spot on the expiry day. Otherwise, all the money that he has paid as a premium will be forfeited.

American Option – In American Option, the buyer of the option has the right to exercise his option at any time. The settlement in this option is based on the price at the time the buyer exercised the option and not at the price as on the day of expiry. This means that if someone has bought an option of Bajaj Auto with a strike price of 2050, when today its price is 2030, then on any day the price of Bajaj Auto reaches above 2050, then the option buyer can exercise his option. And the seller of the option will have to fulfill his obligation, regardless of the number of days left for expiry.

Those who know about options may raise the question that when we have the right to exercise our option even after 30 minutes of buying the option, if we want, then what difference does it make if it Option European or American?

This question is correct. To know the answer to this question, let us once again look at the example of Ajay and Venu. In this example, if Ajay had the right to come and exercise his option on this agreement at any time in 6 months, and in such a situation, if any rumor spreads that the highway project is about to start, then so be it. As the price of the land may have gone up substantially, Ajay may decide that he will exercise his right of option now and Venu has no way but to sell the land to Ajay (even if He must have an idea that this price has gone up only because this rumor has spread very fast). Since Venu would be taking a higher risk in such an option that Ajay may exercise the option anytime, he would need a higher premium now.

For this reason American options are always more expensive than European options.

You should also know that this is why NSE has left the American option 3 years ago. Now all the options in the Indian market are based on the European option. This means that all the options are exercised only at the price of expiry.

Now we will talk about put options in the next chapter.

The main things of this chapter

• You sell call options only when you are in recession, i.e. your view is Bayerish.
• P & L of selling call options and buying is exactly the opposite of each other.
• When you sell call options, you get a premium.
• The caller seller has to collect a margin in the exchange.
• The profits of selling options are limited. As much as it is getting premium, it can be unlimited losses.
  P & L = Premium – Max [0, (Spot Price – Strike Price)]
• Brake Done Point = Strike Price + Received Premium
  All options in India are European.