Last Monday we explained basics of index options.
In this edition, ET focuses on option sellers and their role, specific to Nifty options.1.
Who is an option sellerOne who sells a call or put option to a buyer for a premium, or price of option.
The seller is obliged to sell an underlier at a specific price to a call buyer by or before expiry of a contract.
He is also obliged to buy an underlier from a put buyer at a specific price by or before expiry of contract.
In Indian context only difference is exchanged.
Examples will be given bearing this in mind.2.
How can this be illustrated with Nifty optionsNifty closed at 10795 (all prices rounded off for convenience) Friday.
On that day 10800 strike call strike is level of Nifty at which seller sells or buyer buys closed at a premium of Rs 150 a share (75 shares make one Nifty contract).
Now assume you purchased a right to buy Nifty at 10,800 by or before Jan 31 expiry by paying Rs 150 a share , and by Jan 31 Nifty closed at 11,000.
Your 10800 strike is Rs 200 in money.
So, you make Rs 50 on an investment of Rs 150 (cost of option).
Only difference is exchanged and no delivery happens.
From sellers perspective he received Rs 150 from you.
His breakeven above which he loses stands at 10,950 (10,800+150).
Above 10,800 his profit keeps shrinking till breakeven point.
The maximum he can earn is Rs 150 a share , while buyers profit is unlimited and loss limited to premium.in that sense option seller receives limited profit but can be exposed to unlimited loss.However, options are priced in a manner that invariably result in sellers pocketing premium paid by buyers.
It is estimated that a seller makes money 8 out of 10 Times, stacking up odds against an option buyer.Now assume Nifty closes at 10,700 or at 10,800 on expiry at Jan 31.
The call option buyer loses all of his premium to seller in former case and his premium drops sharply , to near zero, if Nifty expires at strike he purchased on account of time decay one of a key parameter to calculate an options price.In case of a put buyer, a seller pockets entire premium if Nifty expires above or at strike sold.
He loses if Nifty closes below strike sold minus premium received.
For e.g., he sells a 10,700 put expiring January 31 at Rs 100 a share premium and Nifty closes at 10,800.
The put seller pockets entire premium paid by a put buyer.
But, if Nifty expires at 10,500, seller loses Rs 100.3.
If an option buyer loses invariably why buy optionsSome do it to hedge their portfolios, as in case of buying puts, or simply punting as an option price is a fraction of an underliers cost.
Take Nifty at 10,795 or Fridays closing.
Since one Nifty contract has 75 shares, value of one contract is Rs 8.09 lakh.
The price to buy one call at 10800 strike is Rs 150 a share or at contract value of Rs 11,250 (150X75).
That is just 1.4 per cent of contract cost.