In Continuation with Previous Article Why Retail Traders “Buy Options” and Professional Trader “Write Options”
What is Option Writing
Option Writing means Instead of Buying Options (Buying Call or Put), trader is shorting them, Just Like we short Futures, Option can also be shorted. Universal Rule of Market is Every Buyer will have a Seller so same applies in Options so If Trader A is Buying Option by paying premium , Trader B will short/write it.
This act of selling either calls or puts first, hoping that the value goes down and buy it back at a lower price to earn a profit is called Option Writing.
As I have discussed in Last article Writes always have advantage as Probability of trade going in their favor is 3 times more than buying options.
With Increase in Lot size,many traders are preferring trading in options without having proper knowledge and eventually losing money.
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.
Let me Explain what is Option Premium before we talk about Shorting Options
Option premium, the value of calls or puts that you see on your trading screens has two components, Intrinsic value, and time value.
Option Premium = Intrinsic Value + Time Value
The intrinsic value is the difference between the underlying price and the strike price
|Intrinsic Value (Call) = Underlying Price – Strike Price|
|Intrinsic Value (Put) = Strike Price – Underlying Price|
- If Nifty is at 8100, Intrinsic value of 8000 Nifty calls is 100 (8100 – 8000) which is how much you would get if the option expired right now.
- If Nifty is at 8100, Intrinsic value of 8200 Nifty calls is 0, since it is out of the money which is how much you would get if the option expired right now.
- Similarly if Nifty is at 7900, Intrinsic value of 8000 puts is 0 and 7800 puts is 100.
The Time value is the difference between the Premium and and the intrinsic value
Time Value = Premium – Intrinsic Value
For Eg Nifty is trading at 8000
- Nifty 8100 call is at Rs 87. This premium of Rs 87 is Time Value as Intrinsic Value is 0, Traders Buying this Options is paying for time value only and time value gets reduced as the expiry comes near.
- Nifty 7900 call is at Rs 150. This premium of Rs 150= Rs 100 (Intrinsic value) + Rs 50 (Time Value)
Different types of options
- ITM (In the money), all options which have some intrinsic value. So if Nifty is at 8000, 7900 CE, 7800 CE, 8100 PE, 8200 PE, etc. are ITM.
- OTM (Out of the money), all options which have no intrinsic value and only time value. So if Nifty is at 8000, 8300 CE, 8400 CE, 7800 PE, etc. are OTM.
- ATM (At the money), all options with strike price very close to the market price. So if Nifty is at 8000, 8000 CE and 8000 PE are ATM.
Open Interest (OI)
The total number of open contracts for any option is called its Open Interest. So if Nifty 8000 Nov 2015 8000 CE have OI of 30 lakh, that means all buyers of 8000 CE together hold 30 lakh contracts sold to them by option writers.
Option Writer advantage is Nifty will expire of Expiry Day say at 8000, so all OTM CE and OTM PE Option before and After 8000 will expire at zero ie. 8100/8900 CE will expire at 0 and 7900/7100 PE will expire at 0. OTM Options are around 83% of the total OI so if your write the right option there is high probability of making money.
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.
Please do not be under assumption Option Writers do not lose money, I will try to cover in next article Risk of being Option Writer.