Selling Call Option What is Writing/Sell Call Options in Share Market?

Two sides of the same coin

Let’s understand a with a context to the movie Deewar. Similiarly to the Deewaar brothers, these two parties are two sides of the same coin in Option trading. Unlike their counterparts however, making decisions based on market trends is more important than morality. 

One thing to remember: whatever is the fate of the option seller, it impacts the opposite for the buyer. If one gains Rs 100/-, it automatically means that another loses it. A list of generalisations can be surmised from this:

• The option buyer has limited risk to the amount of the premium they pay, while conversely the option seller is only able to benefit up to the same amount from the premium they have been given.

• When an option buyer has the potential for unlimited profits, it means that the option seller faces the possibility of unlimited risk.

• The breakeven point is where the option buyer begins to make a profit, which is also the point at which the option seller starts to incur losses.

• If the option buyer is making a profit of Rs.X, it indicates that the option seller is experiencing a loss of Rs.X.

• Conversely, if the option buyer is losing Rs.X, it means that the option seller is making a profit of Rs.X.

• Furthermore, if the option buyer believes that the market price will increase, the option seller expects it to either remain at or fall below the strike price, and vice versa.

To gain a better understanding of these concepts, it would be beneficial to examine the perspective of the option seller, specifically focusing on the Call Option in this chapter.

Before we move on, I want to caution you about this chapter – since the option seller and buyer are mirror images of each other, this section could appear repetitive of what we’ve just discussed in the last chapter. Therefore, it might give you the temptation to skim over it. I urge you not to do that and remain attentive for any slight variations which could have a massive influence on the P&L of the call option writer.

 – Call option seller and his thought process

We discussed the ‘Rahul-Arjun real estate situation from chapter 1, analysing three potential outcomes that could bring the agreement to a reasonable conclusion.

1. Rahul, the option buyer, will benefit as the price of the land rises above Rs.500,000.
2. The cost remains level at Rs.500,000; this is favourable for the option seller, Arjun.
3. The rate is less than Rs.500,000, which is a bonus for Arjun since he is an option seller.

It’s evident that selling options gives the writer an advantage – with only one out of three situations favouring the buyer. This alone can provide an incentive for someone to write options, but if they also possess strong market understanding, their prospects for success are even greater.

I should clarify that the possibility of making a profit through option selling relies solely on a natural statistical edge, and I don’t guarantee that it will turn out successful each time.

Let us now review the ‘Bajaj Auto’ case using the chart we looked at in the previous chapter.

• The stock has taken a huge hit, it is obvious that sentiment is incredibly weak.

• Since the stock has been drastically reduced in price, it is likely that many traders and investors are currently in a difficult place, holding long positions.

• Any upward movement in the stock price should be seen as a chance to exit from any long positions held in that stock.

• It’s unlikely that the stock will rise quickly, particularly in the short term.

• Given the expectation that Bajaj Auto’s stock price won’t rise, selling the call option and harvesting the premium may be seen as a sound trading venture.

The option writer arrives at the conclusion to sell a call option due to their thoughts on the future of Bajaj Auto’s price. Most importantly, they think that it won’t increase in the near-term, and selling the call option for its premium is a wise move.

Previously we discussed the significance of selecting the right strike price in options trading. As we continue through this module, we will take a deeper dive into this concept. 

For the time being, let’s assume that the option seller has chosen to sell the 2050 strike option of Bajaj Auto and received a premium of Rs.6.35/-.

Let’s now go through the same exercise previously done to understand the Profit & Loss (P&L) profile of the call option seller, and make the essential generalizations. The idea of an intrinsic value of the option discussed in that chapter still applies here.

Before we move on to analyse the table, it is important to highlight that

1. The ‘premium received’ column has a positive sign, indicating that the option writer has received cash (a credit).
2. The intrinsic value of an option on expiry remains the same regardless of whether it is held by a call option buyer or seller.
3. The slight variation in the calculation of net P&L for an option writer follows a particular sequence.
   1. When an option seller sells options, they receive a premium (let’s say Rs. 10.50). In order to incur losses, the amount lost must exceed this premium. This means that any money lost beyond the premium received will be their actual loss. Therefore, the P&L calculation for the option seller would be ‘Premium – Intrinsic Value’. For instance, if they receive Rs. 7.80 as a premium and then experience a loss of Rs. 5.60, it implies they are still in profit by Rs. 2.20.
   2. On the other hand, the option buyer needs to recover the premium paid before they can achieve a profit. Hence, their P&L calculation is ‘Intrinsic Value – Premium’.

Now that you are familiar with the table, let us take a closer look and make some generalisations, keeping in mind the strike price of 3000.

1. As long as XYZ Company remains below the strike price of 3000, the option seller can benefit from their investment. They receive the entire premium of Rs. 10.50/- as profit without any change.
   1. The maximum potential profit for the call option seller is limited to the premium received, as long as the spot rate remains equal to or lower than the strike price.
2. When XYZ Company exceeds the strike price of 3000, it results in a loss for the option writer. 
   1. The option writer starts to incur losses as soon as the spot price exceeds the strike price, and the gap between these two prices determines the severity of the losses.
3. It is reasonable to infer that, the option seller has limited gain potential and unlimited risk of loss.

We can put these generalizations into an equation in order to calculate the potential profits or losses of a Call option seller.

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

Based on the formula mentioned above, let’s assess the profit and loss (P&L) for various potential spot values at expiration.

The solution is as follows –

Spot Price: 2980

P&L = 10.50 – Max [0, (2980 – 3000)]

= 10.50 – Max [0, -20]

= 10.50 – 0

= 10.50

Spot Price: 3050

P&L = 10.50 – Max [0, (3050 – 3000)]

= 10.50 – 50

= -39.50

Spot Price: 3025

P&L = 10.50 – Max [0, (3025 – 3000)]

= 10.50 – Max [0, 25]

= 10.50 – 25

= -14.50

We can observe that these results align with the generalisations mentioned earlier. The option seller’s profit is restricted to the extent of the premium received when the spot price is below the strike price. As the spot price moves above the strike price, the option seller incurs losses.

Let’s explore the P&L behaviour at and near the strike price to identify the point when the option writer starts incurring a loss.

The call option seller can generate a profit even if the spot price surpasses the strike price, as long as it remains below the strike price plus the premium received. This specific threshold is known as the “break-even point” for the call option seller.

Breakdown point for the call option seller = Strike Price + Premium Received

For example, for XYZ Company:

Breakdown point = 3000 + 10.50

= 3010.50

The point at which the call option buyer reaches their breakeven point coincides with the breakdown point for the call option seller.