Learn the Basics of Option Shorting / Writing

Stock-Market-TrainingI often come across people who enquire on the basics of shorting or writing. This article is dedicated to all those inquisitive people who want to know about option shorting or writing.

Option writing/ shorting is basically the act of selling either calls or puts with a hope that the value will go to zero or buying it back at a low price so as to earn profits from the transactions. Index option trading has captured the market to a larger extent in derivative markets. In year 2012-13, out of the total derivative transaction in NSE, almost 75% share was of index option. If the best is that the market will go up, then most of the retail investors buy call option. However, if the bet is that the market will go down, then most of the retail investors will buy put options.

The words writing/ shorting is used instead of option to denote whether the options were sold first before they were being purchased.

 

Why a short/ write option takes place in the market?

Transacting in derivates is riskier in comparison to transacting in equity or mutual funds. If you look at the past data, then almost 70 to 95% of the transactions are not worth and expire in losses. I know at this point of time, you must be thinking that if the major lot of transactions expire worthless than why people trade in options and if on the one side, the option buyers are taking a high risk then who on the other side actually wins the game. The answer to the second part of the question is “option writers” are the ones who actually mint money when the option buyers lose in a deal. Before seeking an answer to the first part of the question, let us first of all understand the various things related to option.

Option Premium – Option premium is the value of either call or put. It is the sum total of the intrinsic value of the option and the time value.

Intrinsic value – It is simply the value which you will get if your options are expired right now. Let us understand it with the following cases:

  1. The Nifty value is at 5000 and the intrinsic value of 4800 Nifty calls is 200 (5000 – 4800), i.e. you will get Rs. 200 in your pocket if the option has to expire right now.
  2. The Nifty value is at 5000 and the intrinsic value of 5200 Nifty calls is 0, i.e. you will not get any amount in your pocket.
  3. The Nifty value is at 5000 and the intrinsic value of 4800 Nifty puts is 200 (5000 – 4800), i.e. you will get Rs. 200 in your pocket if the option has to expire right now.
  4. The Nifty value is at 5000 and the intrinsic value of 5200 Nifty puts is 0, i.e. you will not get any amount in your pocket.

Time Value – Time value is the premium that is received over and above the intrinsic value of the option. Let us say that the Nifty is at 5270.

  1. Nifty 5200 call is at Rs. 100. Then the intrinsic value is 70 and the time value is 30 and the total premium is 100.
  2. Nifty 5300 call is at Rs. 70. Then the intrinsic value is 0 and the time value is 70 and the total premium is 70
  3. Nifty 5200 put is at Rs. 50. Then the intrinsic value is 0 and the time value is 50 and the total premium is 50
  4. Nifty 5300 put is at Rs. 170. Then the intrinsic value is 30 and the time value is 140 and the total premium is 170

Risks of Option Writing

The buyer of an option has a limited risk, however, the profit potential is unlimited whereas an option writer has an unlimited risk and his profit potential is limited.

If you think that you have the ability to understand and that you can trade in options, then even the piece of advice would be – play safe as the risks inherent are more.

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