The Hindu Business Line : Selling options: Profiting from negatively-skewed strategies

Desperate times call for desperate measures. That is, perhaps, one of the reasons why many novice traders are now resorting to selling options. This article discusses such short trade set-ups. It also shows how option sellers can choose appropriate strikes using the behavioural biases of option buyers.

Negatively skewed strategy

Selling options is risky. The reason is that options carry asymmetric payoffs. A call option buyer gains more when the underlying moves up, than she loses when it goes down. Similarly, a put option buyer gains more when the underlying goes down, than she loses when it goes up.

The opposite is true for the option seller. The maximum profit on a short call is the premium received. The maximum loss, however, is unlimited. Likewise, the maximum profit on a short put is the premium received. The maximum loss is capped, as the underlying cannot go below zero.

Why then do traders indulge in selling options? The reason is because of the lure of negatively-skewed profit-loss distribution. Typically, 80 per cent of options expire worthless. This means that option sellers realize maximum profits (keeping the premium) on 80 per cent of the options during any month. The asymmetric payoff, however, means that short sellers will suffer large losses when 20 per cent of the contracts expire in-the-money (ITM).

A negatively-skewed strategy refers to a distribution structure that has higher probability of small gains and lower probability of large losses. This is one of the reasons why selling options is not for novice traders. Besides, selling options attract margin requirements at the NSE, which means more trading capital.

Trade set-ups

Traders typically sell calls when they expect the underlying to decline or sell puts when they expect the underlying to move up. Such a strategy is, however, sub-optimal. Why?

Long calls are preferable to short puts when the underlying is expected to move up.

Similarly, long puts are preferable to short calls when the underlying is expected to decline.

Selling options are, hence, optimal only when the underlying is likely to move sideways or when volatility is expected to decline. It is typical for experienced traders to sell options during the expiration week, as time decay is higher during that period.

It is preferable to sell options on the Nifty index than on the underlying. The reason is that price jumps on individual stocks are more frequent than jumps on a broad market index. And price jumps can lead to large losses on the short option positions.

The next important step is to choose the appropriate strike. Option sellers can choose the strike that carries the highest implied volatility based on the Black and Scholes model.

Traders who do not use the model can choose the strike that carries the highest trading volumes. The reason is this: Option premium consists of intrinsic value and time value. Intrinsic value is the difference between the spot and the strike price for ITM options. The time value is the residual factor in the option premium including the behavioural biases of traders; higher demand for a strike leads to higher time value. And higher time value leads to higher time decay, which translates into higher gains for option sellers.

Now, strikes (near-ATM and near-OTM) that are closer to the spot price carry higher volumes for two reasons.

One, these strikes require lower outlay, as they carry no intrinsic value. And two, if long traders’ view turns out right, these strikes expand generously to carry intrinsic value.

It, hence, pays to sell near-ATM and near-OTM options when the underlying is expected to move sideways.

Selling the January 3000 Nifty options (Wednesday prices), for instance, will generate optimal gains if the trader expects sideways movement in the index. It is, however, important to remember that selling options are risky, as they carry limited gains and higher losses.

(The author is an investment strategist. He can be reached at enhancek@gmail.com)

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