Let’s try to answer it in detail today: Let’s go back to the same example of car insurance.
If I buy a car of Rs 10L and pay a car insurance premium of Rs 50,000.
Just Rs 50,000, I can now have unlimited gains, as I need not worry about my car anymore; however, I paid this Rs 50K premium to the car insurance company, and this car insurance company is now exposed to unlimited risk, as I can claim any big amount in case of an accident.
But in the long run, are insurance companies making losses?
The answer is NO, and as you can guess, the reason being, few cars go for claims and rest just pay insurance money worthless.
So even if the car insurance company has to shell out big money in case of a few car accidents, they still end up making big profits as the probability of these settlements will be very less, and other car users will pay a premium without any claims.Similarly, in Option trading, an option seller purely relies on probabilities, the chances of turning an option against a seller is very less.
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Let’s understand this with an example:
Consider Maruti Suzuki is at Rs 8900, and the option seller is bullish, he will sell OTM Put. Say, MR X, sold 8500 PE of Maruti at Rs 28.
Now, let’s discuss the scenarios after taking this position:
If Maruti goes up, Mr X’s view becomes right, the put prices will go down and MR X will start making money, so this is a winning scenario.
If Maruti stays flat at around 8900, the put prices will still go down due to premium decay, giving gains to MR X, this is also a winning scenario.
If Maruti goes down, against the view of Mr X, but does now go below 8500, then due to premium decay 8500PE will still become Zero on expiry giving profits to Mr X, this is also a winning scenario.
If Maruti crashes down heavily and goes below 8500, Mr X will lose heavily and this is a losing scenario.
So, you can see that out of 4 cases, Mr X lost only once, and hence his win probability is very high, sometimes option sellers make money even if the market is against them.
This is the reason many big traders prefer option writing over Option buying.
To showcase a classic example, here is the back office report of my May 2023 trades. All option selling.
Realised profits in Green are small, and some losses are a little big, exactly like the case of the insurance company, but overall, we made very good returns of approx. 7% on our principal.
So, with this we complete option selling, and now you know why people do option buying and option selling.
I want to leave you with a few questions: Can we do Option Buying and selling together? Will it have more profitability? Will it improve our win rates?
Let’s answer all of this in the next series: Advanced Option Strategies.
(The author is Co-founder Algofox.com)
(Disclaimer: Recommendations, suggestions, views, and opinions given by experts are their own. These do not represent the views of the Economic Times)