Make money by writing call & put options

TATrader · #1 19th April 2005, 07:19 AM

Make money by writing call & put options

Quote:

WRITING OPTIONS

Writing out-of-money options allows you to garner small and consistent returns, during adverse market conditions. Read on to figure out what these options are and how you can make a quick buck on them

WHAT are the chances of SBI touching Rs 780 by the end of this month? Not very bright, you might say.Then, why not write an SBI Rs 780 call option and earn some low risk income? This practice is popularly known as writing out-of-money options. As a result, you can hope to make some decent income in the form of the premium received on writing the option.

Writing options

First, you must be familiar with option basics. An option can be either out-of-money, in-the-money or at-the-money. A call option is said to be in-the-money if the current market value of the underlying share is above the strike price of the option. Similarly, a put option is said to be in-the-money if the current market value of the underlying asset is below the strike price of the option. For instance, if the current price of Infosys is Rs 2,100, an Infosys 2,000 call option (strike price is Rs 2,000) and Infosys 2200 put option (strike price is Rs 2200) are in-the-money.

At-the-money simply means that the current market value of the underlying asset is the same as the strike price. For instance, if the current price of Infosys is Rs 2,100, then Infosys 2100 call and put options (strike price is Rs 2,100) are at-the-money.

A call option is said to be out-of-money if the current price of the underlying share is below the strike price of the option. A put option is said to be out-of-money if the current market value of the underlying share is above the strike price of the option. For instance, if the price of Infosys is currently Rs 2,100, then an Infosys 2,200 call option (strike price is Rs 2,200) and Infosys 2,000 put option (strike price is Rs 2,000) are outof-money.

Out of money options

Logically, you should write a call option when you expect the underlying stock to stay at the same level or fall. Similarly, you could write a put option when you expect the price to stay at the same level or rise. As an option buyer, your risk/ loss is limited to the premium that you have paid. On the other hand, as an option seller, your risk is unlimited whereas your gains are limited to the premiums that you earn.

Hence, writing call and put options are considered to be quite risky as the losses can be unlimited, if the value of the underlying asset increases above the exercise price. For instance, if you write or sell one Infosys 1 month at-the-money call option at a strike price of Rs 2,100, when the cash price is also Rs 2,100, you would get a decent premium
of anywhere between Rs 50-70. But the risk
you would be carrying is quite high. If the
price of Infosys rises to more than Rs 2,400 on expiry, then you could stand to lose anywhere between Rs 220-250 per share (Since, the option is cash-settled, the loss will be the cash settlement amount, reduced by the premium).

However, it is always less risky to write out-of-money options, as the strike price is at a premium to the spot price. For instance, if you had written an April call option on SBI at Rs 740, on the March 29, 2005 (when the cash price was Rs 640), you would have received a premium of Rs 5.35 per share.The writer of such options gains because of the erosion of time value of options. As on April 11, 2005, the premium on the same Rs 740 call option falls to Rs 2.45, as the time to maturity narrows down. So, you could just wait till the option matures (at the end of April), hoping that it will expire as worthless. Or, if you feel that would be risky, then you could even square up your position, and earn a net of around Rs 3.

In the same manner, if you had written out a Rs 600 April put option on SBI, you would have earned a premium of Rs 7. As on April 11, 2005, the premium on this option was around Rs 3.5. Currently, there is a Rs 780 April call option on SBI, which could earn you a premium of Rs 1.95. Even though you stand to get a much lower premium than you would earn, by writing options quoting nearer the current market price, the risk is also much less, in such options.

Many a times, it gets difficult for investors to exit positions that they have built over a period of time. At such times, they could look at selling ‘out of the money’ call options to hedge themselves and get an additional cushion on the portfolio values. Besides, a study of the options market shows that 80-90 per cent of options expire worthless. Hence, by following the strategy of writing out-of-money options, you can garner small and consistent returns, during adverse market conditions.

IN BRIEF

An option can be either out-of-money, inthe-money or at-the-money.

A call option is said to be out-of-money if the current price of the underlying share is below the strike price of the option.

It is always less risky to write out-ofmoney options as the strike price is at a premium to the spot price.

The writer of such options gains because of erosion of the time value of options.

Although the premium earned on such options is not much, the risk is also low.

A study of the options market shows that 80-90 per cent of options expire worthless.

sh50 · #2 19th April 2005, 08:05 AM

This is an excellent write up. The basics could not have been explained better. Since one gets to hear a lot of covered call writing, hope that will follow.

joy_mitali · #3 19th April 2005, 06:33 PM

Hi TATrader and sh50,
Thanks for starting such a grand topic,which I was also planning to start with.
I would like to add a few points to this topic,regarding some of the practical hazards,before one starts buying and selling options.

Before playing with options(unlesss suggested by someone else),u really must
have a fairly good idea,reading the market movement ,specially the fluctuation of the NIFTY,and the corelation of the particular stock (on which u r planning to play) with the NIFTY movement.Also one must have a fairly good knowledge of the option pricing model,and know how to effectively use the option calculator(very few people actually know it ,with due respect to the senior analysts,and of those few knowledgeble people,only a handful actually know how to implement the theories into practise in
the practical reality;---the misfortune is that these few handful keep this knowledge as a well guarded secret,and never tend to share it ).

The first practical hazard that comes into cosideraton is that we tend to forget the brokerage aspect while making all calculations for maximising our profit in option trading.Even though the premium amount involved is small,but the brokerage involved is quite significant.I will give u concrete example.
I consider the case of buying NTPC 's 95 CALL to be expired on 31st march'05 at a premium of 2.25per unit(lot size 3250)This is one which I actually traded with.While the total premium amount turns out to be 7312.5, the brokerage (along with all the taxes,effectively .1321% for buying and .1103% for selling, as per my case) turns out to be 417.66(only the buying part).Surprising, forthe newbees,isn't it???
Now we consider some probable cases:
The call option price rises to 2.75----Profit Rs. 856(Net brokerage paid Rs. 768)
The call option price falls to Rs.1.75---Loss Rs.2389.48(Net brokerage paid Rs.764)
Believe my words ,all the newbees---It is the loss which mostly occurs.I am seen it for myself.For the sake of testing ,I saw my entire money getting eroded away--I could have easily got out bearing ab loss of Rs.1200-Rs 1400,but I wanted to feel the pain of losing the wealth ,with an undercurrent false belief that the price would afterall riseand give me profit.(A bit crazy may be,but that's the way it is to learn acc. to my opinion!!I do not sometimes understand how a person like me having a budgeted resource can make such funny decisions!!)

Anyway ,the actual reality is that,--option trading is more of a hedging tool(like an insuranse policy),than a trading tool.But I still strongly feel that when we can really come in harmony with the stock market,it can obviously be used as a trading tool,(in fact a intraday trading tool)and can be judiciously utilised for maximising the profit with a very limiited resourse.

Dearest TaTrder,(along with Traderji,Creditviolet and all other true knowledgables):given the permission, I can discuss some of the topics of option trading,with ur expert commentry in between all along,and rectifying the mistakes which I'm sure am going to make.I have made a significant researsh in option trading ,
and I'm ready to share it if the forum wants it.(I actually want to write a book on option trading in the perspective of Indian market,and have just initiated it)

But then, their are also a lot of interesting permutations and combinations in the option strategies,which can be only known by experienced traders like u,all.

It will be a pleasure and pleviledge for all of us,if we can consider different hypothetical cases and analyse them bit by bit,keeping the theoritical and practical solutions side by side.After all,trading in option is more lke a chess game,where u always have to forsee all the possible moves of the greatest hypothetical player(the stockmarket itself)--- in advance and act accordingly.
NB:If u kindly state the proper difference between option buying and selling
and calland put option writing ,Iwill be obliged to u.
Regards,
joy_mitali

Traderji · #4 19th April 2005, 06:45 PM

Hello Joy,

We welcome your comments/articles on this subject. Please feel free to post your comments here.

Here is a link for an option calculator:

http://www.888options.com/desk/options_calc.jsp

kannamthanam · #5 19th April 2005, 10:45 PM

Writing out of the money options is a relatively safe trading method.However considering that you have to keep a margin equivalant to a futures contract,it would be much more profitable to take positions in futures in a strongly trending market whereas in case of trading market where your positions may get whipsawed option selling would be much more profitable,because you have the edge of decay in timevalue component of the option price- just my two cents

K Kannamthanam

sh50 · #6 20th April 2005, 08:13 AM

It is said that "Wise men learn from the mistakes of others and fools from their own". In that context, Joy letting us learn from his mistakes is really appreciable specially considering the fact that trading is a largely individual endeavor where there is no boss to correct your mistakes proactively.

We normally sell out of the money call and put options on both sides and try to cover before the expiry date. This is more of an amateurish thing though no harm if it makes money.

Following joy's example, if everyone can share both mistakes and examples of the fancy option strategies, it would be a very good learning experience.

joy_mitali · #7 21st April 2005, 04:35 AM

Hi,TATrader,Sh50,Traderji,and all others in this forum,

Before proceeding with the actual aspects of option trading,I would like to discuss
for the newcomers,(I,also ,myself ,belong to that category only)why we can switch over to option trading,instead of only depending on the equity market for churning profits(or loses!!whatever way we want to interpret!!).

In the truest sense ,option trading is more of a hedging tool(which will be discussed much later),than a trading tool.But then,if utilised very cautiously,with a proper understanding of the directional movement of the stock (under consideration) ,and its corelation with the movement of the NIFTY,it can be utilised as a specialised trading tool(even a good intraday tool),for maximising the profit with the minimum investment.

I,being a common man ,would say it from my perspective,why I got interested in option trading.

Suppose ,I have a capital of Rs. 10,000 and nothing else.I have scrutinised the scrips of the stockmarket very minutely,and have made a small database of some of the best scrips in the market;for eg. INFOSYS,TCS(the irony's of today's market!),DIVIS LAB,Dr. REDDYS,etc.But then ,as these stocks are quite high priced,and are not suitable for my budget,---I have narrowed myself down to TISCO and NTPC.

Now, considering an investment in TISCO:
An investment of Rs.10000 enabled me to buy 28 shares of TISCO at the level of Rs.347.2 per share(as on 19th April'05 close)

I also, am certain that,there is a good probablity of TISCO bouncing back to a level of Rs.375 withen the next 4 days.
Suppose,considering an hypothetical situation ,my assumption turns out to be true,and I sell all the 40 shares which I have bought making an investment of Rs.10,000 on 4th day.
Then considering my all inclusive brokerage of .644%(in both legs):
My Net Profit =Rs.648.17(which is availableto me 2 days afterI have sold;considering my selling to be either on Mnday or Tuesday)
Effective period of investment=6days
Thus effective %monthly return=[(((648.17/9784.2)*100)/6)*30]%=33.1233%

Now ,I come to the profitability in option trading:
On 19th April, I buy 390's CALL of TISCO at a premium of Rs. 1/unit(LOT_SIZE=1350)

After 4 days ,my predction came out to be true.
It can be shown through an option clc that the option premium will now rise to approx.
2.6
here,my net investment=1350+697.52(Brok.)=2047.52
My net return (excl.Brok.)=2925.399(Brok.584.6)
Net Profit=877.87
%monthly return=214.374%!!!!!!!
UnBelievable!!! Who says out of money call transaction an ametureist work!!!Probably
it is the imaginative creation of a super professional!!!
{NB

on't believe that such transaction are always possible.Actually this type of call buying and selling is really Ameturistic.)

Actually a complete knowledge of Nifty movement and a good forsight can give a real good profit even in day trading in options.

This much for today only.
Regards,
joy_mitali

sh50 · #8 21st April 2005, 08:49 AM

Nice of you to spare so much time for writing such examples, Joy. The leveraging works negatively also and you stand to lose substantially too- a fact that must be mentioned. The most important thing is that your reading of the market has to be correct; only then all the fancy hedging strategies can work.

joy_mitali · #9 22nd April 2005, 08:09 PM

Dearest Traderji and respected all seniors and juniors,

Today I feel like writing something.Good,or bad,Plz do critise so that I can rectify myself and try to make better postings for the benefit of all.

VOLATILITY--It's significance in option trading
---------------------------------------------------------------

Before starting with the role of Volatility in the aspect of Option Trading,I would like to discuss a little bit regarding the valuation of an option.
An Option-- being a derivative instrument ,--which gives the buyer certain rights, --is bound to be a valuable security in its own right.Hence, it is very essential,to understand how an option is valued in the stock market.

In order to understand what makes an option valuable,we need to have a proper knowledge of the Option Valuation Model.

The value of an option primarily comprises of 2 components--
1)Intrinsic Value
2)Time Value(Previously reffered to as "Gamble Element")

The "Intrinsic Value" of an option is defined as the value ,a buyer of an option would realize ,on the expiary of the option,or on its exercise.

For a Call option:
Intrinsic Value = Current Share Price - Exercise Price
For eg.,
A)Considering the scrip--NTPC which was quoating Rs.84.55 (LTP) on 20th April'05,and whose 80 CALL option primium was:
OPTSTK-NTPC-28APR2005-80-CA ----- Rs. 5.05(LTP)

Its Intrinsic Value=Rs.84.55 - Rs.80 = Rs.4.55

For a Put option:
Intrinsic Value = Exercise Price - Current Share Price

For eg.,
B)Considering the scrip--NTPC which was quoating Rs.84.55 (LTP) on 20th April'05,and whose 90 PUT option primium was:
OPTSTK-NTPC-28APR2005-90-PA --- Rs. 5.6(LTQ)

Its Intrinsic value = Rs.90 -Rs. 84.55 = Rs. 5.45

**The intrinsic value of an option cannot be negative;its minimum possible value is 0

Qs.1)For OPTSTK-NTPC-28APR2005-90-CA --Re.0.35,(NTPC price-Rs. 84.55) what is the Intrinsic value?
Qs.2)For OPTSTK-NTPC-28APR2005-80-PA --Re.0.3(NTPC price -Rs.84.55) what is the Intrinsic value?
(I do not know the ans. in certanity.Plz, Seniors,give a proper ans with explanation)

The "Time Value" of an option is defined as the difference between the Total Option Value and Intrinsic Value, ie,
Time Value = Total Option Value - Intrinsic Value
For eg. as in (A) above:
Time Value = 5.05 - 4.55 = Re. 0.50
Again,
For eg. as in (B) above:
Time Value = 5.6 - 5.45 = Re. 0.15
Qs.3)Can the time value of an option be negative?If yes,what is its signaficance?
[Plz,Seniors,do give a proper ans. of this Qs.]

In case of call options, the Intrinsic Value is directly proportional to the share (also known as underlying security)price.ie,
More is the price of the Scrip(ie,share) ,more is the Intrinsic Value,and viceversa.

For eg.,if the price of NTPC becomes Rs.85.25(LTP 21st April,05),from Rs.84.55(LTP20th April'05):
then the Intrinsic Value becomes Rs. 5.25, from Rs. 4.55

Similarly if the NTPC price moves down,then the Intrinsic Value also decreases by an equivalent amount.

But in case of PUTS, the correlation is absolutely negative,ie Intrinsic value is inversely proportional to the share price.

For eg. if ANDHRA BANK is quoting at Rs.100.45(20th April,LTP),
then Intrinsic Value of [OPTSTK-ANDHRABANK-28APR2005-110-PA
---Rs.10.55(LTP)] is Rs. 9.55.
If ANDHRA BANK moves down from 100.45 to 98.45(hypothetical value), then the Intrinsic Value of ANDHRA BANK 110 PUT rises fron Rs. 9.55 to Rs. 11.55(ie,increase of Rs.2)

As ,we have seen that ,Intrinsic Value has a direct correlation with the share price(The correlation may be positive in case of CALLS,and negative in case of PUTS) ,but Time value of an option does not depend upon the price of a share---it primarily depends upon 2 factors:
a)Time left to expiary
b) Volatility
Common logic only tells us that ,--more the number of days left for the expiary of the option,the more the chance there exists for the share's price to rise further(always assuming a bullish trend in the market--what an irony!!) and thus the option also gets highly valued.

As a concrete example,on 22ndAPRIL'05:TISCO (LTP):Rs.361.7

OPTON NAME LTP VOL OPEN HIGH LOW Prev.Cl.
OPTSTK-TISCO-28APR2005-370-CA 3.00 406350 7 .80 7.80 2.8 7.6
OPTSTK-TISCO-26MAY2005-370-CA 12.55 51975 15.25 15.25 12.00 16.55

OPTSTK-TISCO-28APR2005-370-PA 11.00 71550 7.10 12.25 7.05 8.05
OPTSTK-TISCO-26MAY2005-370-PA 19.45 14175 17.00 24.00 15.00 12.50

Thus we observe that ,time left to expiary has a direct effect on the CALLS and PUTS equally.

At this point I would like to say something more about the Intrinsic Value of an option.
Considering 2 more parameters,--the time to expiary (t)and the risk free interest rate(R.F.I.)

A more stringent defination of an intrinsic value of an option is:
Intrinsic Value= Current Share price - Exercise price(1+ R.F.I.)exp(-t)
where t = no. of years to expiary
[Not properly understood;clarification required from seniors]

Now comes the interesting aspect of Volatility.But I will try to discuss it some other time.
Regards,
joy_mitali

kmm · #10 28th April 2005, 08:51 AM

hi joy
would like to share my experiences in option trading.
to understand the whole process i started off with just buying a NIFTYput option when the trend was down.next day the price went from rs 22 to rs 39!! sold it for a 77% profit.But wait...the price still went up till Rs.54.The typical feeling of having lost out on more profit set in.Enthused by the first attempt, bought one more Put option @ Rs. 31.But alas the nifty price went up ,my put option price fell and the loss was equal to the profit i made earlierSo i squared i off .But to my added agony, the nifty went down again and my second option price went up and more than doubled again.So if i had held on maybe would have seen profit in the second case.

I can understand the reasons for this pattern.typical new trader psychology of greed and fears .not studying the nifty wave patterns.resistance and support.

My additional attempts also resulted in net loss due to the above reasons.- wrong analysis and not following basic rules. i have set these rules for myself for my future trading
1. Study trends and wave patterns and resistance / support daily
2.Strict stoploss to be planned.
3.Profit target to be set and exit.Do not mind if it increases after that.Bcos in options the rate of return seems higher in short term
i plan to hold to nifty ptions for holding period of a few days only.more time is eroding the value.is my analysis correct.

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