You might have heard several times that option trading is very risky. One should be able to manage their risks otherwise they can wipe out their entire capital. I disagree! With option selling, one can not just wipe out their entire capital but can lose much more than that, to the extent that they can go bankrupt. In this post, I will explain with examples why options selling is risky and how can one effectively manage those risks. This will protect your capital by turning huge loses into smaller one, and will even buy some time to turn it into a profitable trade.
Risks associated with selling options
A trader can sell two types of option, a Call or Put option. Selling any of these options comes with following types of risks.
This is the risk due to movement of the underlying in the opposite direction.This can be explained with the following examples:
- Selling a Call option means that a trader is betting on market not going up. So if I sell a Nifty Call option at strike price of 12250 with a premium of Rs. 155, I expect to collect the entire Rs.155 premium if Nifty does not go above 12250 till expiry. Even if Nifty ends up below 12405 (12250 + 155), I will make a profit. If Nifty goes above 12405, I will start making losses. This is how the P&L chart looks like.
- Selling a Put option means that a trader is betting on market not going down. So if I sell a Nifty Put option at strike price of 12250 with a premium of Rs. 115, I expect to collect the entire Rs. 115 premium if Nifty does not go below 12250 till expiry. Even if Nifty ends up above 12185 (12250 – 115), I will make a profit. If Nifty goes below 12185, I will start making losses. This is how the P&L chart looks like.
- This is the risk due to increase in volatility. Note that the premium price can increase even if the underlying does not move. This will happen because of an increase in the implied volatility. As the volatility increases, the price of premium increases which leads to loses. Explained below with an example.
- Nifty is trading at 12050. Implied volatility of 12050 CE is 13.1 with 19 days left to expiry. Below is the P&L chart. There is a profit of Rs. 1,144
- On the same day, if Nifty still remains at 12050 , but the implied volatility increases to 15.1, below is the P&L chart. We can see that the trade is now making a loss of Rs. 491. This happened because premium shot up due to volatility.
Why is vega risk scary!
Traders tend to be careful of the delta risk by monitoring the price of the underlying, But the vega risk usually gets ignored which may lead to huge loses. A significant increase in volatility is enough to wipe out your entire capital and much more. I will explain with following example, how much capital can be wiped out with an increase in volatility.
Below is the P&L chart if we sell a 12050CE on a typical day. Nifty is trading at 12050, few days have passed and Nifty did not move much. Thus there is a handsome profit of ~1.1k Rs.
Suddenly a black swan event occurred which shot up the volatility 10 times. Below is the P&L chart of the same 12050CE.
We can see that we are in Rs. 2 lakh loss. This is huge given the margin required to sell the option is Rs. ~1 lakh. We are not only losing the entire margin but also Rs. 1 lakh more in losses. The broker will send a margin call and we might be forced to close the position taking huge loses.
Though above scenario happens rarely, but when it happens, a trader will not be left with any money to continue their trading journey. One loss is enough to wipe out years of profits and much more.
How to manage risk with selling options
Although delta & vega risks are real, but this does not mean we should stop selling options. I will explain how we can sell options safely and still be profitable.
Stop loss market order
If you sell naked options, put a stop loss market order. This will ensure that your loss does not exceed a given value. This is a very effective strategy to cut loses in most of the cases but it has its own flaws:
- In case of sudden market crash or a gap up/down, stop loss order might be triggered at a much higher price leading to huge loses. Even if you replace it with stop loss limit order, that might not be executed at all.
- Stop loss order will get hit as soon as the option premium reaches the threshold price. This will not give an opportunity to profit in case the market reverse before expiry, which happens in many cases.
To counter the flaws of stop loss we have a much better strategy. Instead we should buy OTM option as insurance which I will explain below.
Buy OTM option as insurance
This is a much better strategy than putting stop loss order. We hedge our sell position by buying cheap OTM option as insurance. This will help manage risk of trade going wrong or volatility shooting up.
Managing delta risk
Say Nifty is trading at 12050. 12050CE is priced at Rs.186. If I have a bearish view of the market, I can chose to sell 12050 CE. To manage risk, I will buy 12450 CE at a premium of Rs. 28. This way, my profit has reduced from Rs.186 to Rs.158. (Rs.186 – Rs.28) , but I have capped my loss to Rs.242 (12450 – 12050 + 158). So even if the market goes to 13000, I can not lose more than Rs.242. Below is the P&L chart. [Note that lot size of Nifty is 75, hence 75*242 = ~18k loss]
But the benefits do not stop here. We will analyse the black swan event example when the volatility increases significantly. I will show how this strategy can be used for managing the vega risk.
Managing vega risk
Let’s say Nifty is trading at 12050 and a rare Black Swan event. The volatility shoots up 10 times. For a naked 12050CE, P&L chart looks as below:
We can see that the loss is 2 lakh rupees. Remember that margin required for selling the option is ~1 lakh rupees. So we would have lost the entire margin and still 1 lakh rupee more in loses. Broker will instantly give the margin call and we might be forced to close our position taking huge losses.
On the contrary , if we hedge our 12050CE selling by buying a 12450CE, below is how the P&L chart looks.
Even when the volatility shoots up 10 times, the losses are just ~36.5k Rs. This is well within our margin limit. We can see that vega risk has been managed to a great extent. Due to lesser loses, we will not be forced to close our position. We can wait for volatility to come down or till expiry to minimise losses. We can even get a profitable trade if market reverses direction and the volatility cools off.
By buying insurance in form of OTM options, we have reduced our profits but we have managed to trade much more safely against the hidden risks. We have managed to get the following benefits out of it:
- Capped our maximum loss in case of gap up/down or a black swan event.
- We are not forced to cut down our position due to margin call from the broker.
- Even if market goes significantly in opposite direction, we can wait till expiry to profit from market reversals.
- Even if the volatility shoots up, we can wait for it to cool off and cut down our loses.
Option selling is mostly profitable but could be a nightmare during extreme events. Let me know in the comments section about your experience with selling options. Please subscribe to my blog and follow me on twitter to get all the latest updates.
Want to know the right market conditions to buy or sell a straddle ? Read about it here