Option Writing: A friend or a foe? Here are 3 types of option writing
Time and again we are reminded of constantly depreciating characteristic of ‘Options’. While the certainty of it makes this rather a straight forward feature to trade.
We can mix it with directional moves and its impact that is the premiums of options become more complicated than the underlying themselves.
However, there are times and ways to attack this wasting characteristic of options but one needs to keep in mind what kind of option writer one wants to be and then stick to the mechanism of that kind of writer.
Today we will talk about 3 kinds of option writing:
Non-Directional writing is mostly the starting point for most of the option writers. In a lull one or two months of selling both calls and put options give money and it becomes handy so one puts it in practice.
Believe me, these lulls can last long enough to get one hooked to it. Talk about the 400 points range in recent times or the biggest I have traded so far was 2009-2010.
As easy as it is to make money out of writing without any mechanism, in this lull if one wants to make a full-time trade allocation to this exercise, there has to be a mechanism in place, because once a trending move sets in it could ruin a year-long pay-off in just a month.
1. There are various tools in place from simple ones like Bollinger Bands (can be googled) or quite simply the heaviest call and put open interest strikes to ballpark a trading range, use them to choose the strike rather than randomizing the strike selection.
2. Always have an exit strategy in place before entering (True for any kind of writing). I have resorted to either buying farther Options (Higher Call & Lower Put than Shorted) or placing a stop loss at twice the premium received
This is one of my favorites where one has a clear cut intention which is aligned with the obligation that the short option comes with, making it technically risk-free to trade Options Short.
For Example, if one holds a stock trading at 100 and intends to sell it at 110, in that case, go ahead and Sell the Call of 110 @ 1. In case, the stock ends up at 114 on expiry, it will be sold @ 114, Option would incur a loss of 4.
Adjusting for the upfront premium received (114 – 4 + 1), the stock is sold at 111. On the other hand, if the stock fails to deliver once again next month one more option could be sold, which in turn would add up to the selling price.
Similar Trade can be done by selling a Put if one intends to buy lower.
Caveat: Remember the intention shown to the market and honor it by buying/selling the underlying if the Option expires with a Loss.
Lastly, we have Directional writing:
This is a little sophisticated writing, where medium-term views on a stock are traded with a short Option instead of a long Option.
The methodology remains more or less the same as the intentional writing with a difference of the underlying.
Instead of underlying, there are stop losses that are observed and the trade is exited if the stock moves unfavourably beyond a point.
Participation led to liquidity and longer periods of lull seems to have pushed the participants towards this technique of writing. Nonetheless if one has the directional expertise, this could very well be a good money maker.
Caveat: We need to account for the failures. I would still say no matter how confident, whenever writing on Direction, it is prudent to have a long Option in place. Be it the most distant Call or Put but it will still keep the maximum loss Known.
(The author is CEO & Head of Research at Quantsapp Private Limited)
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