One of the much touted jargon of trading industry is, that option value decays over the time, hence with selling options – easy and consistent premium can be earned on a regular basis, everyone wants to believe that, specially new option sellers fall into prey for that, In this post we will discuss risks involved in options selling.
First of all let say that, I am not debunking option selling or instead suggesting to buy options, For nimble traders in fact it does work with right risk management in place. But just ask yourself, if selling were so easy everyone would have done the same? and no one has to lose money in stock market!
Big money fund managers sell options but they do it for hedging purposes this is, so called option experts won’t tell you. And to profit in selling a naked option you must have a robust prediction mechanism in place, there is no excuse for that along with that you need a stop loss too.
We hear all the time, that options decays its value over the time, and there are popular pricing models (Black scholes) for that like, can it be simple as plain vanilla ? Well not denying that there is drops at discrete times, but its not like they lose value every hours or so, certainly in a longer expiry like months or more you will see options price losing its value on some days.
Wait, but peoples want to apply that on day trading or where holding period is few days. Let me tell you as long as there is a hope in traders who bought those options, it will not drop 1 penny, real options work like that, get this clear.
First thing to keep in mind is in options risk-reward don’t work in favor of a seller , an option seller may get 10-10 points in 3 trades and can lose 50 in 2 trades later. that’s how options price moves, to put it in simple words option price don’t change similar on either sides of falling and rising market.Without bringing in complexity of option pricing models, let us see little bit of math of this then it will be clear.
We can roughly say, at any point of time option moves by certain percentage of its own price, this is in either direction, in technical terms we call this delta, so a 100 rs option may be changing +/- 5% every 5min (5 rs either side), when the options are rising the further change also becomes large, for example that 100 rs option becomes 150, next change will be 7.5rs and thus options rise at exponential rate, on the opposite side if market is falling further drop is curtailed on every next drop. hope this is clear.
Reality of option selling trading do not rely on prediction or trend following rather a guess of market limits, so you may be having an opinion that market will remain range bound around +200 and -200 during this expiry so you can take a position