Comment on Basics on Options Shorting/Writing

yashjhaveri1 commented on 26 Jun 2014, 05:15 PM

Hi Subcit,

Shorting both Calls and Puts is inherently a risky strategy! (you are betting on the market staying stagnant i.e non volatile) Even if the market remains stagnant – the daily profit earned is very small.

as a simple rule the price of an option is made up by 2 elements : Intrinsic Value + Time Value

(The price of an option is effected by :
a) Change in Value of the underlying
b) Interest Rate change
c) Changes in Volatility
d) Time to Expiration

in your example if the intrinsic value of the call option is Rs. 35 therefore it has a time value of Rs. 5 (Rs 40 being total vlaue – Rs 35 being intrinsic value)
Also, assuming there are 10 trading days to expiration.

As a thumb rule you can assume that Rs. 0.50 (Rs. 5 / 10 trading days) will be be the DAILY decay in time value. (for getting the exactly decay value for a day – use black scholes options calculator)

Again since the Total Option value consists of 2 elements : Intrinsic Value + Time Value.

The instrinsic value is determined by the underlying
eg. in case of call the instrinsic value is the Maximum of
– (Underlying Spot price – Strike Price),
– ZERO.

and the decay (Reduction) in time value will be Rs. 0.50 at the end of every trading day.

But Note :
1) if during the trading day volatility increases (the options value would increase)
2) if there is any change in interest rate announced the price of the option would increase / decrease
even if there is no change in price of the underlying on that particular day.

Also, if during the day if the Value of the underlying remains unchanged,
you get a profit of Rs. 0.50 on the call option + Rs. 0.50 on the Put option (assuming the DAILY decay of time value of put option is also Rs. 0.50 per day)
Thus a total profit of Rs. 1.00………….THIS STRATEGY IS REALLY RISKY TO ACHIEVE THIS “LOW PROBABILTY” OF “SMALL” PROFIT

Que : You must be wondering who would be on the selling side of options (if it is so risky)
Ans : its usually traders who have set up a hedging strategy

Hope this helps!

Yash J

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