Options Buying vs Selling: Every transaction, right from the days of the Barter system always has had a counterparty. Every seller got to have a buyer to consume the supply. Similarly, in Options too, every option buyer needs to have a counter option seller willing to give his right on the underlying asset.
An options buyer is one who is willing to pay a premium in advance, for having a right to buy/sell (depending on Call/Put) underlying asset on expiry. And an option seller is one who receives a premium as a fee for surrendering his right on Asset till expiry.
Benefits of Options Buying
- Options give you the power of Leveraging, as with limited capital one is able to ride the bigger move.
- The Risk involved here is to the tune of Premium paid. Say, if someone is buying a Nifty call option by paying a premium of 40. And a Nifty lot consists of 75 units. Therefore, the total premium paid will be equal to 40*75 = Rs. 3,000. So, by paying a premium of Rs. 3000 one is able to ride the full move.
- The option buyer has the opportunity of earning unlimited profit by just paying a premium and the loss is limited to premium invested.
Benefits of Options Selling
To understand this, let us understand the scenarios option contracts move to at expiry:
- When the Spot price moves above the strike price at expiry, the option expires In The Money. Options buyers gains and makes money.
- When the Spot price is at or near the strike price at expiry, the option expires At The Money. The Option seller earns the premium received as his income as the contract expires worthless for the buyer.
- When the Spot price is below the strike at expiry, the option expires Out Of Money. The Options sellers earns the premium received as income as the contract expires worthless for buyer.
So, from the three scenarios mentioned above, the Option Buyer makes money in one of the scenarios and the option seller stands to make money in two scenarios. Let us understand more on options buying vs selling with the help of an example:
Take for example if the Nifty spot is trading at 9325, and the option buyer buys weekly call option of 9400 by paying a premium of 120, then the
— Calculation for In the Money Call option P/L
- Spot price at Expiry: 9700 (Say)
- Premium: 120
- Strike Price: 9400
- Profit for Option Buyer: (9700-9400-120)*75 = Rs. 13,500
- Loss for Option Seller: Rs. 13,500
— Calculation for At the Money Call option P/L
- Spot price at Expiry: 9405 (Say)
- Premium: 120
- Strike price: 9400
- Loss for option Buyer: (9405-9400-120)*75 =Rs. 8,625 loss
- Profit of Option Seller: Rs. 8,625
— Calculation for Out of Money Call option P/L
- Spot price at Expiry: 9275 (say)
- Premium: 120
- Strike Price: 9400
Here, loss for option Buyer: (9275-9400-120)*75 = Rs. 18375 loss. But the maximum loss for an option buyer is to the tune of premium paid. So the maximum loss to Option Buyer in Out of Money Call option is Rs. 9000
- Profit of Option Seller: Rs. 9000
The option buyer starts making money once he reaches a breakeven point on his trade. The Breakeven point is calculated as follows: Breakeven Point = Strike price + premium paid
There is no Margin required to buy an option. Just the premium is required to be paid to option seller. Say, to buy a Nifty call option, the premium required to be paid is 40. Then, the total premium to be paid will be = 40*75 = Rs. 3,000.
But in case of selling options, margin along with exposure has to kept with the broker, to account for day to day volatility. The margin is required to be deposited here because seller of an option is exposed to unlimited risk.
Margin for selling option = Initial Margin + Exposure Money
Which strategy to use?
There is no straight answer as to which is better: Buying or Selling. Each have their own benefits and negatives:
1. In case of buying, the buyers risk is limited to premium paid and in return, he gets right on underlying asset till maturity. But selling has its own benefit of receiving income (premium) beforehand and have to pay anything only if the spot price goes above the strike price. Even in that case also the seller has the protection of premium beyond strike price. Therefore, the real loss for seller happens (in case of call option) when: (strike price + premium) < spot price.
2. The option buyer is always in the game to make money, as long as the option does not expire but his probability reduces as the contracts keep moving closer to expiry. And option seller is always exposed to unlimited risk but his risk reduces with time because of less time for the individual assets to make substantial movement in a particular direction.
3. Both option buyers and sellers have the option to exit their trades before expiry. If the option buyer sees that the premium of his position is more than what he paid and he wants to book profit, he can easily do that via options market. And similarly, the option seller can get out of his position if he sees a substantial move of premium in his favour or sees a position going against him.
From the above discussion, we can easily conclude by saying that there is no right strategy as to buying or selling options. And there are arguments both in favour and against options buying vs selling.
Choosing the right strategy depends on one’s objective, rational, and risk-taking appetite.
Hitesh Singhi is an active derivative trader with over +10 years of experience of trading in Futures and Options in Indian Equity market and International energy products like Brent Crude, WTI Crude, RBOB, Gasoline etc. He has traded on BSE, NSE, ICE Exchange & NYMEX Exchange. By qualification, Hitesh has a graduate degree in Business Management and an MBA in Finance. Connect with Hitesh over Twitter here!