Who are option traders?
Normally in equity, HNI and ultra HNI investors and corporates — categorised as clients — proprietary traders, DIIs (who can only buy but not write or sell) and FIIs dabble in selling and buying of options. More recently retail level investors and traders have jumped on to the options bandwagon. In commodity derivatives, actual users — companies, farmer processor organisations, etc, — could be the sellers, while buyers could include retail traders, or speculators, and wholesalers.
What does selling entail?
Selling of a call or put option on any asset class entails limited profit and unlimited risk. The maximum profit is in the form of premium received from a call and put buyer. The loss is unlimited in case the market moves against the seller.
How does loss or gain happen?
Take the Nifty closing at Monday’s level of 15,115.8. Assume a bullish trader expects Nifty to hit 15,500 by expiry on Feb 11 (weekly expiry). He buys a call option at 15,150 strike for Rs 108 a share (75 shares make one Nifty lot). If the Nifty expires this Thursday at 15,500, he is in-the-money by Rs 350 a share. However, since he paid Rs 108 to the seller, his gain excluding taxes and brokerage is Rs 242. That is what he gets paid by the seller. Now, assume the Nifty expires at or below 15,150. The option becomes worthless due to decay in time — a chief determinant of option pricing — and the buyer forfeits the premium to the seller. The seller’s maximum gain is Rs 108 a share. But maximum loss is unlimited. While an option buyer’s maximum risk is the premium, the seller whose loss could be unlimited, has to place a margin to cover the risk with the exchange clearing corporation through his broker. The margin is equal to that for buying or selling a Nifty futures contract.
How does a seller price an option?
By using the Black Scholes pricing model, whose basics will be explained in the next edition.
