Options are derivative instruments, which gives the buyer, the ‘right’ to buy or sell an underlying security at a pre-determined price. This price is called ‘strike price’ of that option.
The price of an option is based upon the price of a security, time to expiry of option and volatility in the security.
This price in totality is called premium, which is paid by buyer.
There are various guides and books which describe the concept of pricing of options in more detailed manner.
This guide is about how you can use options for making money consistently from the stock market.
Options as instruments came into the picture to provide a way to big traders as the hedge against their portfolio risk. When there is big enough trade position in a certain stock or index stocks, then to protect that position there are limited options:
- You short equivalent value futures. This required MTM ( mark to market) margin maintenance in a trading account as well maintaining of future trade position too. The upside is that you don’t lose the value of future as the price is not time-dependent.
- You buy options(call or put depending on portfolio positions). This required little money and provides good cover portfolio too. The downside risk is that you lose money in the end when an option expires worthless.
In reality, this reason of buying options constitutes little part of the total trading volume of options on an exchange ( mainly NSE).
So who makes the majority portion of options trading volume on daily basis. Yes, the retail traders & certain proprietary trading desks.
Now comes the funny part, only one of these two trading factions make money in trading options.
And you guessed it right. The proprietary trading desks make money in options trading on a more consistent basis as compared to retails traders.
The reason is simple: They sell options more than they buy them!
Welcome to the world of option selling
Options selling (as it is self-explanatory) is opposite of options buying.
Which means if you are bullish in market outlook, then rather then buying a call option, you actually sell a put option.
This works in a different way as compared to buying an option.
When you buy an option, you only pay a premium. Which means, let’s say any call option of NIFTY is trading at ₹100, you only pay that price into the size of one lot of NIFTY (75) to buy that option.
100*75 = ₹ 7500
This is the only amount that is utilized (and at risk) when you buy that option.
Now from here, the upside is unlimited whereas downside is 0. Nothing more.
Whereas, the party of the other side of this trade, which just sold you this option has just blocked the margin money equal to trading 1 lot of NIFTY ( around ₹50k) for selling this option to you.
To that party, the money (potential profit) is this amount you paid as a premium: ₹7500.
Whereas, the potential loss is unlimited (if the price of that option keeps going up).
Then why will that party take such risky trade for limited profit!?
Because, statistically, there are higher chances of your option losing its value faster, due to the market being in range, as compared to a meteoric rise in price ( which you expected) when you bought the option.
[A note: 90% options expiring worthless is a myth- Read more]
The reason is time decay.
What is time decay?
There are two components in the price of every option: inherent value and time value
The inherent value of an option is the value with which the price of underlying security is above, from the strike price of an option. So, let’s say NIFTY is at 9840 and 9800 call option is at price 60. Then in this scenario, the inherent value of this option is:
9840-9800 = 40
Thus, ₹40 out of the price of ₹60 is the inherent value of this option. (And also it is the in-the-money option: Read more).
This, brings up the next question? Why is this option at ₹60 then? Where is this extra ₹20 coming from?
In simplest words, each option is valid till its expiry date. The time value in options is dependent on how time is left in expiry.
Further in future, the expiry of an option is, higher is the time value in the price of that option.
Which means, time value in the same strike price based option is higher with expiry in next cycle(month) as compared to one this month.
You can read more about this concept here.
Thus, the concept and practical approach to time decay.
As I just mentioned, time value in the price of an option is based on time to expiry of that option. Which means, when the time of expiry comes near, the time value decreases.
This is called time decay.
Now, how does that helps us?
Here comes the beautiful part of the market being in range (some traders like to call this stage as consolidation).
Again, statistically speaking, a market is trending only for around 20% of times. Rest of the time, it stays in a range.
And this is where consistent money making comes into the picture.
You see, unless market breaks out of a range, it will stay in old ranges.
Which means, every option at the boundaries of the range has higher chances of losing time value each month.
This is the method used by most of the option writers. Find the range(read how to find range), sell options with a strike price at that range, take the premium and earn money.
Things to be careful about:
- As with any trading approach, first paper trade. Learn the system, learn how to decide which options to sell.
- This method is for generating medium level returns on a more consistent basis as compared to actively trading. But that doesn’t make it risk-free. Learn to manage your positions and risk, ideally before you put your money in the market.
- There are two exits from any trading position. Either when you are in profit and it is planned exit Or when the original hypothesis (the range in this case) is no longer true, the stop loss exit. Don’t overstay in your position.
I would like to read your opinion about option trading. Do leave a comment about it.
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