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

Two Sides of the Same Coin

Let’s understand this with a context to the film Sholay. Similarly to the Sholay characters, these two parties represent two sides of the same coin in options trading. Unlike their counterparts however, making decisions based on market trends proves more important than sentiment.

One thing to remember: whatever fate befalls the option seller impacts the buyer oppositely. If one gains Rs 100, it automatically means 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, whilst conversely the option seller is only able to benefit up to the same amount from the premium they have received

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 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 superior 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 previous 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 Their Thought Process

We discussed the ‘Vikram-Suresh property situation’ from chapter 1, analysing three potential outcomes that could bring the agreement to a reasonable conclusion:

Vikram, the option buyer, will benefit as the price of the property rises above Rs 6,00,000

The cost remains level at Rs 6,00,000; this is favourable for the option seller, Suresh

The rate is less than Rs 6,00,000, which is a bonus for Suresh 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 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 ‘Hero MotoCorp’ case using the chart we looked at in the previous chapter. Let’s revise it again.

The equity has taken a substantial hit; it is obvious that sentiment is incredibly weak

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

Any upward movement in the equity price should be seen as an opportunity to exit from any long positions held in that equity

It’s unlikely that the equity will rise quickly, particularly in the short term

Given the expectation that Hero MotoCorp’s equity price won’t rise, selling the call option and collecting 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 Hero MotoCorp’s price future. Most importantly, they think that it won’t increase in the near term, and selling the call option for its premium represents 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 2,850 strike option of Hero MotoCorp and received a premium of Rs 18.75. Please refer to the option chain provided below for additional details.

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 generalisations. 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:

The ‘premium received’ column has a positive sign, indicating that the option writer has received cash (a credit)

The intrinsic value of an option on expiry remains the same regardless of whether it is held by a call option buyer or seller

The slight variation in the calculation of net P&L for an option writer follows a particular sequence

When an option seller sells options, they receive a premium (let’s say Rs 15.80). 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 15.80 as a premium and then experience a loss of Rs 8.20, it implies they are still in profit by Rs 7.60.

On the other hand, the option buyer needs to recover the premium paid before they can achieve 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 2,850:

As long as Hero MotoCorp remains below the strike price of 2,850, the option seller can benefit from their investment. They receive the entire premium of Rs 18.75 as profit without any change

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.

When Hero MotoCorp exceeds the strike price of 2,850, it results in a loss for the option writer

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.

It is reasonable to infer that the option seller has limited gain potential and unlimited risk of loss

We can put these generalisations 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: 2,820

P&L = 18.75 – Max [0, (2,820 – 2,850)]

= 18.75 – Max [0, -30]

= 18.75 – 0

= 18.75

Spot Price: 2,920

P&L = 18.75 – Max [0, (2,920 – 2,850)]

= 18.75 – 70

= -51.25

Spot Price: 2,880

P&L = 18.75 – Max [0, (2,880 – 2,850)]

= 18.75 – Max [0, 30]

= 18.75 – 30

= -11.25

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. Refer to the table for this analysis.

The call option seller can generate 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 Hero MotoCorp:

Breakdown point = 2,850 + 18.75

= 2,868.75

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

For those exploring equity investment opportunities through a stock broker or consulting with a financial advisor, understanding option selling mechanics proves essential when navigating the stock market. Whether evaluating trading calls or utilising a stock screener to identify opportunities, comprehending call option writing strategies enables more sophisticated market participation.

Visit https://stoxbox.in/ for comprehensive educational resources on call option selling strategies and risk management tools.