Bought an Option Sold Option for a Loss Bought the Same Option and Sold It Again for a Loss

4.1 – Two sides of the same coin

Do you think the 1975 Bollywood super hit picture show 'Deewaar', which attained a cult status for the incredibly famous 'Mere paas maa hai' dialogue ☺? The motion picture is nigh two brothers from the same mother. While one brother, righteous in life grows up to become a cop, the other brother turns out to be a notorious criminal whose views most life is diametrically reverse to his cop brother.

Well, the reason why I'm talking about this legendary moving picture now is that the option writer and the option buyer are somewhat comparable to these brothers. They are the two sides of the aforementioned money. Of course, different the Deewaar brothers there is no view on morality when information technology comes to Options trading; rather the view is more on markets and what one expects out of the markets. Nonetheless, in that location is one thing that y'all should think here – whatever happens to the option seller in terms of the P&L, the exact opposite happens to choice heir-apparent and vice versa. For case if the pick author is making Rs.70/- in profits, this automatically means the option buyer is losing Rs.70/-. Here is a quick list of such generalisations –

• If the choice buyer has express gamble (to the extent of premium paid), then the option seller has limited profit (once again to the extent of the premium he receives)
• If the option buyer has unlimited profit potential then the selection seller potentially has unlimited chance
• The breakeven betoken is the bespeak at which the option buyer starts to make money, this is the exact same bespeak at which the choice author starts to lose money
• If pick buyer is making Rs.X in turn a profit, then it implies the option seller is making a loss of Rs.X
• If the choice buyer is losing Rs.X, then it implies the option seller is making Rs.10 in profits
• Lastly if the option buyer is of the stance that the market price will increment (in a higher place the strike price to exist particular) then the option seller would be of the opinion that the market volition stay at or below the strike cost…and vice versa.

To appreciate these points further it would make sense to take a look at the Call Choice from the seller's perspective, which is the objective of this chapter.

Before we proceed, I have to warn y'all something about this chapter – since there is P&L symmetry betwixt the option seller and the heir-apparent, the word going forrad in this chapter will look very similar to the discussion we just had in the previous chapter, hence at that place is a possibility that yous could but skim through the chapter. Please don't do that, I would suggest you stay alert to notice the subtle difference and the huge touch on it has on the P&L of the phone call option writer.

iv.2 – Call option seller and his idea process

Recall the 'Ajay-Venu' real estate example from chapter 1 – we discussed 3 possible scenarios that would have the agreement to a logical conclusion –

1. The price of the land moves above Rs.500,000 (good for Ajay – selection heir-apparent)
2. The price stays apartment at Rs.500,000 (good for Venu – option seller)
3. The toll moves lower than Rs.500,000 (good for Venu – option seller)

If yous notice, the option buyer has a statistical disadvantage when he buys options – but ane possible scenario out of the 3 benefits the option buyer. In other words 2 out of the 3 scenarios benefit the option seller. This is just i of the incentives for the option writer to sell options. Besides this natural statistical edge, if the pick seller as well has a expert market place insight then the chances of the pick seller existence assisting are quite loftier.

Please do annotation, I'thousand simply talking about a natural statistical edge here and by no way am I suggesting that an option seller will e'er brand money.

Anyhow let us at present take up the same 'Bajaj Automobile' case we took upward in the previous chapter and build a case for a telephone call option seller and understand how he would view the same state of affairs. Allow me repost the nautical chart –

• The stock has been heavily beaten downwardly, conspicuously the sentiment is extremely weak
• Since the stock has been so heavily browbeaten down – it implies many investors/traders in the stock would be stuck in desperate long positions
• Any increase in price in the stock will be treated as an opportunity to leave from the stuck long positions
• Given this, there is piffling adventure that the stock toll will increase in a hurry – especially in the near term
• Since the expectation is that the stock price won't increase, selling the Bajaj Auto'due south phone call selection and collecting the premium tin exist perceived as a good trading opportunity

With these thoughts, the option author decides to sell a phone call pick. The most important point to note here is – the option seller is selling a telephone call pick because he believes that the price of Bajaj Machine will Non increment in the near future. Therefore he believes that, selling the call option and collecting the premium is a good strategy.

As I mentioned in the previous affiliate, selecting the correct strike price is a very important aspect of options trading. We will talk about this in greater item as we go frontwards in this module. For now, let usa assume the option seller decides to sell Bajaj Auto's 2050 strike option and collect Rs.half-dozen.35/- as premiums. Please refer to the option concatenation below for the details –

Permit us at present run through the same exercise that we ran through in the previous chapter to sympathise the P&L profile of the telephone call option seller and in the procedure make the required generalizations. The concept of an intrinsic value of the selection that we discussed in the previous chapter will hold true for this chapter too.

Series No.	Possible values of spot	Premium Received	Intrinsic Value (Four)	P&50 (Premium – Iv)
01	1990	+ 6.35	1990 – 2050 = 0	= half dozen.35 – 0 = + six.35
02	2000	+ vi.35	2000 – 2050 = 0	= 6.35 – 0 = + 6.35
03	2010	+ 6.35	2010 – 2050 = 0	= vi.35 – 0 = + 6.35
04	2020	+ 6.35	2020 – 2050 = 0	= 6.35 – 0 = + 6.35
05	2030	+ vi.35	2030 – 2050 = 0	= half-dozen.35 – 0 = + 6.35
06	2040	+ 6.35	2040 – 2050 = 0	= 6.35 – 0 = + 6.35
07	2050	+ vi.35	2050 – 2050 = 0	= half dozen.35 – 0 = + vi.35
08	2060	+ 6.35	2060 – 2050 = 10	= 6.35 – ten = – three.65
09	2070	+ 6.35	2070 – 2050 = 20	= half-dozen.35 – 20 = – 13.65
x	2080	+ 6.35	2080 – 2050 = 30	= vi.35 – xxx = – 23.65
11	2090	+ 6.35	2090 – 2050 = xl	= 6.35 – 40 = – 33.65
12	2100	+ 6.35	2100 – 2050 = 50	= 6.35 – fifty = – 43.65

Before we go along to talk over the table to a higher place, please note –

1. The positive sign in the 'premium received' column indicates a cash arrival (credit) to the option author
2. The intrinsic value of an option (upon expiry) remains the same irrespective of call pick buyer or seller
3. The net P&L calculation for an option writer changes slightly, the logic goes like this
   1. When an choice seller sells options he receives a premium (for example Rs.6.35/). He would experience a loss only afterwards he losses the entire premium. Meaning after receiving a premium of Rs.6.35, if he loses Rs.v/- information technology implies he is all the same in turn a profit of Rs.i.35/-. Hence for an option seller to experience a loss he has to first lose the premium he has received, any money he loses over and above the premium received, will be his real loss. Hence the P&50 calculation would exist 'Premium – Intrinsic Value'
   2. You lot can extend the aforementioned argument to the pick buyer. Since the pick heir-apparent pays a premium, he get-go needs to recover the premium he has paid, hence he would be profitable over and above the premium amount he has received, hence the P&Fifty calculation would be ' Intrinsic Value – Premium'.

The table higher up should be familiar to you at present. Permit us inspect the table and make a few generalizations (practice bear in mind the strike toll is 2050) –

1. As long as Bajaj Motorcar stays at or below the strike price of 2050, the pick seller gets to make coin – as in he gets to pocket the entire premium of Rs.vi.35/-. Yet, practice note the turn a profit remains constant at Rs.vi.35/-.
   1. Generalization i – The telephone call pick writer experiences a maximum profit to the extent of the premium received as long as the spot price remains at or beneath the strike toll (for a call option)
2. The option author experiences a loss as and when Bajaj Auto starts to motion above the strike price of 2050
   1. Generalization 2 – The phone call option writer starts to lose money as and when the spot cost moves over and above the strike price. College the spot price moves away from the strike price, larger the loss.
3. From the above ii generalizations, it is fair to conclude that, the option seller tin can earn limited profits and tin feel unlimited loss

We can put these generalizations in a formula to estimate the P&L of a Call pick seller –

P&L = Premium – Max [0, (Spot Toll – Strike Price)]

Going by the above formula, let's evaluate the P&L for a few possible spot values on death –

1. 2023
2. 2072
3. 2055

The solution is every bit follows –

@2023

= 6.35 – Max [0, (2023 – 2050)]

= 6.35 – Max [0, -27]

= 6.35 – 0

= vi.35

The answer is in line with Generalization 1 (profit restricted to the extent of premium received).

@2072

= 6.35 – Max [0, (2072 – 2050)]

= half-dozen.35 – 22

= -15.56

The answer is in line with Generalization 2 (Call option writers would experience a loss equally and when the spot price moves over and in a higher place the strike price)

@2055

= 6.35 – Max [0, (2055 – 2050)]

= 6.35 – Max [0, +5]

= half-dozen.35 – 5

= one.35

Though the spot price is college than the strike, the call option author still seems to exist making some coin hither. This is against the two^nd generalization. I'm sure you would know this past now, this is because of the 'breakeven point' concept, which we discussed in the previous chapter.

Anyway allow us inspect this a fleck further and look at the P&L behavior in and around the strike toll to see exactly at which point the option writer will showtime making a loss.

Serial No.	Possible values of spot	Premium Received	Intrinsic Value (IV)	P&L (Premium – IV)
01	2050	+ six.35	2050 – 2050 = 0	= six.35 – 0 = vi.35
02	2051	+ half-dozen.35	2051 – 2050 = i	= six.35 – ane = 5.35
03	2052	+ 6.35	2052 – 2050 = 2	= vi.35 – two = 4.35
04	2053	+ 6.35	2053 – 2050 = iii	= 6.35 – 3 = 3.35
05	2054	+ 6.35	2054 – 2050 = 4	= 6.35 – iv = 2.35
06	2055	+ 6.35	2055 – 2050 = v	= 6.35 – 5 = 1.35
07	2056	+ six.35	2056 – 2050 = 6	= vi.35 – 6 = 0.35
08	2057	+ half dozen.35	2057 – 2050 = 7	= 6.35 – seven = – 0.65
09	2058	+ six.35	2058 – 2050 = eight	= half-dozen.35 – 8 = – 1.65
ten	2059	+ six.35	2059 – 2050 = 9	= vi.35 – 9 = – 2.65

Conspicuously even when the spot price moves higher than the strike, the selection writer nevertheless makes money, he continues to make money till the spot toll increases more than strike + premium received. At this indicate he starts to lose money, hence calling this the 'breakup point' seems advisable.

Breakdown indicate for the call selection seller = Strike Price + Premium Received

For the Bajaj Auto example,

= 2050 + six.35

= 2056.35

So, the breakeven betoken for a telephone call option buyer becomes the breakdown betoken for the call option seller.

4.iii – Call Option seller pay-off

As we accept seen throughout this chapter, at that place is a great symmetry between the call choice buyer and the seller. In fact the same tin can be observed if we plot the P&Fifty graph of an option seller. Here is the same –

The call option sellers P&L payoff looks like a mirror paradigm of the call option buyer's P&L pay off. From the chart in a higher place yous can find the following points which are in line with the give-and-take we have just had –

1. The profit is restricted to Rs.vi.35/- every bit long every bit the spot price is trading at any toll beneath the strike of 2050
2. From 2050 to 2056.35 (breakdown price) we can see the profits getting minimized
3. At 2056.35 we can come across that there is neither a turn a profit nor a loss
4. Above 2056.35 the phone call option seller starts losing money. In fact, the slope of the P&L line clearly indicates that the losses start to increase as and when the spot value moves abroad from the strike price

4.4 – A notation on margins

Think almost the take a chance profile of both the phone call pick buyer and a call option seller. The phone call pick heir-apparent bears no take chances. He just has to pay the required premium corporeality to the telephone call selection seller, against which he would purchase the right to buy the underlying at a later point. Nosotros know his chance (maximum loss) is restricted to the premium he has already paid.

However, when you lot think about the take chances profile of a call option seller, we know that he bears an unlimited risk. His potential loss can increment as and when the spot toll moves higher up the strike toll. Having said this, remember about the stock substitution – how can they manage the risk exposure of an option seller in the backdrop of an 'unlimited loss' potential? What if the loss becomes and so huge that the option seller decides to default?

Clearly, the stock exchange cannot beget to permit a derivative participant to acquit such a huge default risk, hence information technology is mandatory for the choice seller to park some money equally margins. The margins charged for an selection seller is similar to the margin requirement for a futures contract.

Here is the snapshot from the Zerodha Margin calculator for Bajaj Auto futures and Bajaj Auto 2050 Call option, both expiring on thirty^thursday April 2015.

And here is the margin requirement for selling 2050 call choice.

As you can see the margin requirements are somewhat similar in both the cases (option writing and trading futures). Of course at that place is a small difference; we will deal with it at a later stage. For now, I only want you lot to notation that option selling requires margins similar to futures trading, and the margin corporeality is roughly the aforementioned.

4.v – Putting things together

I hope the last four chapters have given you all the clarity yous need with respect to call options ownership and selling. Dissimilar other topics in Finance, options are a piffling heavy duty. Hence I guess it makes sense to consolidate our learning at every opportunity and and so continue further. Here are the fundamental things you should remember with respect to buying and selling call options.

With respect to option buying

• Yous purchase a call option only when you are bullish about the underlying asset. Upon expiry the phone call option will exist profitable only if the underlying has moved over and higher up the strike price
• Ownership a telephone call option is likewise referred to as 'Long on a Phone call Pick' or simply 'Long Call'
• To purchase a call option you need to pay a premium to the pick writer
• The telephone call option heir-apparent has limited take chances (to the extent of the premium paid) and an potential to make an unlimited turn a profit
• The breakeven point is the point at which the call selection buyer neither makes coin nor experiences a loss
• P&Fifty = Max [0, (Spot Price – Strike Price)] – Premium Paid
• Breakeven point = Strike Cost + Premium Paid

With respect to pick selling

• You sell a call option (likewise called option writing) only when yous believe that upon expiry, the underlying asset will not increase beyond the strike toll
• Selling a telephone call option is also called 'Shorting a call option' or simply 'Brusque Call'
• When y'all sell a telephone call option you receive the premium amount
• The profit of an selection seller is restricted to the premium he receives, however his loss is potentially unlimited
• The breakdown point is the betoken at which the telephone call option seller gives upward all the premium he has made, which means he is neither making money nor is losing money
• Since curt option position carries unlimited risk, he is required to deposit margin
• Margins in case of curt options is similar to futures margin
• P&L = Premium – Max [0, (Spot Price – Strike Price)]
• Breakdown point = Strike Cost + Premium Received

Other important points

• When you are bullish on a stock you can either buy the stock in spot, buy its futures, or buy a call option
• When you lot are surly on a stock you tin either sell the stock in the spot (although on a intraday basis), brusque futures, or short a telephone call pick
• The calculation of the intrinsic value for call selection is standard, it does not change based on whether you lot are an selection buyer/ seller
• However the intrinsic value adding changes for a 'Put' selection
• The cyberspace P&L calculation methodology is different for the call option heir-apparent and seller.
• Throughout the last 4 chapters nosotros have looked at the P&L keeping the expiry in perspective, this is only to assist you understand the P&L behavior ameliorate
• One need non wait for the option expiry to effigy out if he is going to be profitable or not
• Nigh of the option trading is based on the change in premiums
• For example, if I accept bought Bajaj Auto 2050 call choice at Rs.6.35 in the forenoon and by apex the aforementioned is trading at Rs.9/- I tin can choose to sell and book profits
• The premiums modify dynamically all the time, it changes because of many variables at play, we will empathize all of them equally we keep through this module
• Telephone call option is abbreviated equally 'CE'. And so Bajaj Auto 2050 Call option is too referred to as Bajaj Machine 2050CE. CE is an abbreviation for 'European Call Option'.

four.6 – European versus American Options

Initially when option was introduced in Bharat, there are two types of options available – European and American Options. All alphabetize options (Smashing, Bank Nifty options) were European in nature and the stock options were American in nature. The difference between the two was mainly in terms of 'Options exercise'.

European Options – If the option blazon is European then it ways that the option buyer will have to mandatory wait till the expiry date to do his right. The settlement is based on the value of spot marketplace on decease day. For case if he has bought a Bajaj Auto 2050 Call option, then for the heir-apparent to be assisting Bajaj Auto has to go higher than the breakeven point on the twenty-four hours of the expiry. Fifty-fifty not it the option is worthless to the buyer and he will lose all the premium money that he paid to the Choice seller.

American Options – In an American Pick, the pick buyer can exercise his right to buy the option whenever he deems advisable during the tenure of the options expiry. The settlement is dependent of the spot market place at that given moment and not really depended on expiry. For instance he buys Bajaj Car 2050 Call option today when Bajaj is trading at 2030 in spot market and there are 20 more days for expiry. The next day Bajaj Machine crosses 2050. In such a case, the heir-apparent of Baja Auto 2050 American Telephone call choice can practice his right, which means the seller is obligated to settle with the option buyer. The expiry date has little significance hither.

For people familiar with option you may take this question – 'Since we can anyway buy an option now and sell it subsequently, possibly in 30 minutes afterward nosotros purchase, how does it matter if the pick is American or European?'.

Valid question, well remember well-nigh the Ajay-Venu example once more. Here Ajay and Venu were to revisit the agreement in 6 months time (this is like a European Option). If instead of six months, imagine if Ajay had insisted that he could come anytime during the tenure of the understanding and claim his right (like an American Option). For case at that place could exist a strong rumor about the highway project (afterward they signed off the agreement). In the back of the stiff rumor, the land prices shoots up and hence Ajay decides practise his right, clearly Venu volition be obligated to evangelize the land to Ajay (even though he is very clear that the country price has gone upward because of stiff rumors). At present because Venu carries improver risk of getting 'exercised' on whatever day as opposed to the day of the death, the premium he would demand is also higher (so that he is compensated for the risk he takes).

For this reason, American options are always more expensive than European Options.

Also, yous perhaps interested to know that about 3 years agone NSE decided to go rid of American selection completely from the derivatives segment. So all options in India are now European in nature, which means the buyer tin can exercise his option based on the spot price on the expiry day.

We will now continue to understand the 'Put Options'.

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Key takeaways from this chapter

1. Yous sell a call option when you are bearish on a stock
2. The call option heir-apparent and the seller have a symmetrically reverse P&Fifty behaviour
3. When you lot sell a telephone call selection y'all receive a premium
4. Selling a telephone call selection requires you to deposit a margin
5. When you lot sell a call option your profit is limited to the extent of the premium you receive and your loss tin can potentially be unlimited
6. P&L = Premium – Max [0, (Spot Price – Strike Price)]
7. Breakup point = Strike Price + Premium Received
8. In Bharat, all options are European in nature

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Source: https://zerodha.com/varsity/chapter/sellingwriting-a-call-option/

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