Have you ever bough or sold an Out-Of-The-Money (OTM) Option?
Wait a minute.
Do you know what an Out-Of-The-Money Option is?
If you buy out-of-the-money options at unreasonable premiums or at far away strike prices, an Options Writer will consider you to be an extremely rash trader. This is being politely.
To be blunt, he regards you as an idiot trader but nevertheless loves you, because…
AN OPTIONS WRITER MAKES HIS MONEY BY EATING PREMIUMS FROM THE OPTIONS HE WRITES (SELLS).
THE OPTIONS WRITER ALSO KNOWS THAT AT LEAST 50% OF OPTIONS EXPIRE WITHOUT BEING EXERCISED. So, if he plays it right, his chances of making profits are up at least 50% even before he starts writing.
The Options Writer is an extremely sharp trader who works with tools that constantly update him on the profit or loss potential of the option he has sold.
We will get to these tools at the end of the article. Let’s start:
SECRETS OF OPTIONS WRITERS
1: Options writers know that shorting options is a dangerous game and therefore they largely square up their position by the end of the day unless the profit margin is massive (in which case they set a higher Stop Loss in the next trading session).
2: Options writers always judge the trend. If the trend is bearish, they Write Call Options.
If the trend is bullish, they Write Put Options.
As an example, the trend these days (1-6-18) is that Nifty stocks are rising while the midcaps are falling. So the Options Writers will be active writing calls of FNO stocks that do not feature in the Nifty.
Similarly, when a particular sector becomes a hot topic of discussion, like in the case of consumer durable stocks a couple of weeks back, the Options Writers will write Put options of such stocks and indices.
Therefore, it is important to judge the market trend if you are a Options Writer.
3: These writers love stocks that are not volatile.
The idea is to eat premiums on OTM calls and non volatile stocks do not fluctuate much and therefore writers are not too worried about writing both calls and puts.
Let’s take the example of Infosys which is around 1100. If the annual volatility of the stock is around 10%, it means that the stock will fluctuate in a band of 990-1210 in a year. This implies a fluctuation of Rs 110 either way in a year, which works out to about Rs 9 per month.
So, in such a case the writers are emboldened to write both puts and calls of 1080 (and below) and 1120 (and above) for a given day and walk away with the premiums. Of course if there’s a massive fluctuation in Infosys, they will lose. But by and large this strategy works out in 8/10 stocks.
They also love to sell strangles in non-volatile stocks. A strangle is a strategy in which a trader buys an OTM PE and CE of a volatile stock because he expects the combined premium to move up. In non-volatile stock, the reverse happens (premium moves down)..
4: Options writers do NOT focus on just one or two stocks.
Writing calls and puts for many stocks (some non-volatile, some at overpriced premiums, some at far away strike prices) hedges their risk.
Therefore, the goal is to diversify and not get hooked on to a couple of stocks. Also, writers are cold, calculative and unemotional people.
5: Options writers write at strike prices that are about 15% Out of the Money
Typically, the option writer correlates volatility to the time value of the option. The assumption is that by now you know how to measure volatility (see link above).
If you are yet unfamiliar with the terms, start again and read the Options Basics article that I have linked to.
The Options Writer selects options that are significantly out of the money because he knows that the stock will move up hugely only if there’s a massive move.
OTM Options whose strike prices are +/-15% will likely not be exercised and therefore there are high chances of such options making money for the Writer.
6: Options writers also love to write options when the premium is overpriced.
Now remember this – the Options Writer is mostly looking to square up his position by the end of the day, so he doesn’t care what happens tomorrow.
Therefore, he will calculate the fair value of the stock or index (underlying) and if he finds that the premiums are overpriced, he will write the option even though its strike price is closer to the CMP.
They typically write options that are more than 20% overpriced.
These writers have sophisticated surveillance tools that alert them about overpriced premiums, about their live profit and loss position, and cases where premiums begin to spike.
We don’t and therefore you can use online tools to determine if the premium is fair or not. One such tool is located here.
7. Finally, you need to understand Options Greeks, which are made up of delta, gamma, vega, theta and rho.
Option writers use their values to figure out trades.
This is a rather long topic and I’ll write a post about it.
Meanwhile, you can start doing paper trades from the knowledge you gathered if you want to become an Options Writer. It will take you at least a month and several paper trades to get the hang of the trade.
Alternatively, if you are a plain vanilla investor or an options buyer, then use the information above to understand what to do and what not to do.