Take Cover while Selling Options

As market volatility and uncertainty rise, the average trader is better off taking a backseat and being in the wait-and-see mode. But some of the more experienced and well heeled ones take daring bets to beat the odds. 

1.What is being done in the F&O market? 

A conventional tool for protection used by most lay traders is a put option, which is purchased against downside of an index or stock. But the more experienced and wealthier traders also sell calls when uncertainty rises. In this strategy, instead of a debit as when you buy a put option, an inflow takes place. But this is fraught with risk for if the market rises, it could expose the seller to huge loss. 

2.How does the seller cover himself? 

The seller can actually hold the underlier against which he is selling a call option. 

Say if he has sold a 300 call on SBI, he has sold 3,000 shares (1 lot), he would actual ly hold 3,000 or even more underlying shares of SBI, whose cost is Rs 280. Say if the 300 call expiring on August 31 costs Rs 3, he receives a total of Rs 9,000 from the buyer who's breakeven is Rs 303. Now assume instead of his expectation that SBI wouldn't cross 303 (300 plus the price of each share), it jumps to 306, the call seller has to cough up Rs 18,000 to the buyer, whose net gain is Rs 9,000. That means the seller returns the Rs 9,000 collected from the buyer plus Rs 9,000 from his own pocket. The buyer makes a net gain of Rs 9,000 and the seller a net loss of the same amount. 

However, since the seller holds 3,000 SBI shares, his unrealised gain in the spot market is Rs 18,000 as the SBI options have the cash share as its underlier. This more than makes up for the loss of Rs 9,000. 

3.Are there other combinations by which an option seller can cover himself? 

Yes, he can sell a put option that costs Rs 3 per share, thereby covering himself. If the underlying share jumps to Rs 306, the odds are that the cost of the 260 put option would be nil. So his Rs 3 loss on the call would be offset by the Rs 3 gain on the put. Alternately, he could also buy a futures contract which could offset any loss faced on selling a call. 

4.Should a normal retail investor do such trades? 

F&O trading, if undertaken, should be done in an informed manner and with strict stop losses as losses can be huge. Instead of mere speculation, he could, if he so desires, buy a put option on an index or stock to protect his portfolio value at times of uncertainty . Also remember, that a seller actually cushions himself by pricing options at a higher rate during times of high volatility. Also the seller invariably makes more money than a buyer of options as the buyer is normally, though not necessarily,a man or woman with limited means and limited risk taking ability