Selling Options: Sometimes It Can Be Used Strategically
Options, by their nature, are wasting assets. Over time, factors such as time decay and declining volatility reduce the value of option premiums. Because of this, many option buyers eventually experience their contracts expiring worthless.
Market estimates often suggest that more than 80% of options expire without value. Observing this, some investors choose to take the opposite position — selling options and collecting the premium paid by buyers. At first glance, this may appear to be an easy way to generate income.
However, in investing there is no free lunch. There have been many instances where even highly experienced traders have suffered heavy losses while selling naked options.
Understanding Naked Option Selling
When options are sold without holding the underlying asset, the strategy is known as naked option selling.
In such cases, if the market moves sharply against the seller, the losses can be very large or theoretically unlimited. This is why naked options selling requires extreme caution and risk management.
Despite these risks, options selling can still be useful when applied intelligently as part of a broader portfolio strategy.
Investors receive a premium whenever they sell:
- Call options
- Put options
This premium is paid by the option buyer.
Short Selling and Options
Short selling refers to selling shares that you do not currently own, expecting the price to decline.
There are two common ways to take a bearish view on a stock:
- Selling futures contracts
- Selling call options
In any short position, the trader must eventually buy back the shares or close the position. If the stock price rises instead of falling, the trader faces potentially unlimited risk.
Covered Call Strategy
One of the most common and relatively safer option selling strategies is the Covered Call.
A covered call strategy is generally used by investors who:
- Already own the stock
- Have a neutral or mildly bullish outlook
- Expect the stock to move sideways in the short term
In this strategy, the investor sells call options against shares they already hold.
Example of Covered Call Strategy
Let us consider the example of Larsen & Toubro (L&T).
Assume an investor bought the stock at ₹1400, or traders entered the stock after a breakout above ₹1660 in early June. Over the next month, the stock rises and reaches ₹1900.
At this stage, the investor could sell a call option with a strike price of ₹1900 for a premium of ₹40 per share.
One options contract represents 125 shares, so the premium received would be:
125 × ₹40 = ₹5,000
Scenario 1: Stock Stays Below ₹1900
If the stock price remains below ₹1900 until expiry, the option will expire worthless. The option buyer will not exercise the contract.
The investor keeps the entire premium of ₹5,000 as income.
Scenario 2: Stock Rises Above ₹1900
If the stock price rises above ₹1900, the option buyer may exercise the contract. In that case, the investor will need to:
- Deliver the shares they hold, or
- Purchase shares from the market to settle the obligation.
Why Institutions Use Covered Calls
Large institutional investors often use covered call strategies because they:
- Hold large stock positions
- Generate regular premium income
- Can hedge their positions if markets move sharply
Covered calls therefore allow investors to earn additional income on existing holdings.
Risk Considerations in Options Selling
While selling options provides premium income, it is important to understand the risk-reward balance.
Key points to remember:
- Profit potential is limited to the premium received
- Losses can be significant if markets move sharply
Some traders also believe that selling put options carries higher risk than selling call options.
This is because:
- Stocks often rise gradually
- But they tend to fall sharply during market corrections
When markets fall quickly, put option sellers may find themselves trapped with large losses.
Options selling can be a useful strategy when used with proper knowledge and discipline. Strategies such as covered calls allow investors to generate income while holding stocks.
However, options trading involves complex risks, and it should only be undertaken after fully understanding how these instruments work.
The purpose of this discussion is to build awareness about options selling, not to encourage investors to immediately start trading options.
Understanding both the potential benefits and the risks is essential before using any options strategy in the market.
