Options, by definition, are wasting assets. Factors such as time decay and changes in volatility continuously reduce the value of option premiums.
Many option buyers learn this reality the hard way by watching their option contracts expire worthless multiple times. It is often observed that a large majority of options expire worthless by the time of expiration. Seeing this, some investors conclude that selling options and collecting premiums could be an easier way to generate income.
However, as with all investment activities, there is no free lunch. There are well-documented instances where even highly sophisticated market participants have suffered significant losses while selling “naked” options. Selling options without holding the underlying asset to support the position in case of adverse price movement is referred to as naked option selling, and it involves substantial risk.
That said, options selling, when used thoughtfully and with proper understanding, can sometimes be used to complement or partially protect an existing portfolio and potentially generate additional income.
Investors who sell call or put options receive a premium, which is paid by the option buyer.
Selling Short
When you sell shares of a company that you do not own, it is known as short selling. Short selling reflects a view that the stock price is likely to decline. One way to express this view is by selling futures contracts, and another way is by selling call options.
In a short sale, the seller must eventually buy back the shares. As a result, short selling carries unlimited risk, because if the stock price rises sharply, losses can increase significantly.
There are numerous option strategies available. Below is one example that illustrates how selling call options may be used by investors.
Covered Call Strategy
A covered call strategy is typically used by investors who already own a stock and expect it to remain range-bound or move only modestly over the short term.
This strategy is often employed when:
- The investor has a short-term neutral view on the stock, or
- The stock has already moved up significantly in a short period and is expected to consolidate
Let us again take the example of Larsen & Toubro (L&T).
Assume investors purchased the stock at ₹1,400, or traders entered near the breakout above ₹1,660 in early June. The stock then moved sharply upward and reached levels close to ₹1,900 within a month.
At this stage, investors holding the stock could have written a call option by selling one call contract of the July 2010 series, strike price ₹1,900, at a premium of ₹40.
(Please note: One options contract represents 125 shares.)
By selling the call option, the investor earns the option premium, which is paid by the buyer of the call option. If the stock price remains below the strike price (in this case, L&T closed well below ₹1,900 by the end of July), the option expires unexercised, and the seller retains the full premium.
The premium earned would be ₹5,000 (₹40 × 125 shares).
If the stock price rises above the strike price, the call buyer may exercise the option. In that case, the seller would either deliver the shares already held or purchase shares from the open market to fulfil the obligation.
This approach is commonly used by large institutional investors to generate incremental income on existing equity holdings, while using the underlying shares as a hedge against adverse movements.
The purpose of this article is only to create awareness and understanding of options selling. It does not suggest or encourage that investors should start selling options.
It is important to remember that while profit from selling options is limited to the premium received, the potential losses can be significant.
In my personal view, selling put options generally carries higher risk than selling call options. This is because stock prices often rise gradually but can fall sharply. In such scenarios, sellers of put options may find it difficult to manage exits or control losses during sudden declines.
L&T’s movement from the ₹1,660 range to nearly ₹1,900 has been something I have been tracking since early June.
You may also be interested in understanding Buying Options and how they differ from selling strategies.
Selling options can generate income when used carefully with existing holdings, but risks can be significant. Understanding strategies like covered calls is essential.
Disclaimer
This content is provided for educational and informational purposes only and should not be construed as investment advice, research, or a recommendation to buy or sell any securities or derivatives.
Derivatives trading involves risk and may not be suitable for all investors.
Mutual fund investments are subject to market risks. Please read all scheme-related documents carefully.
