New Retail Traders mostly start with option buying because option selling is expensive. But have you ever thought why option selling is costly? An OPTION SELLER has multiple factors that increase the probability of winning trade . It can be Time Decay , Risk control , winning from range bound markets and lot more but because of the margin requirements , most traders dont start with option selling.
Any transaction requires BUYER and a SELLER . As discussed in last article where we have explained basics of options , Buyer has the “right but no obligation” and Seller is “obligated” in case buyer want to exercise the right.
OPTION BUYER
As an option buyer you pay the premium and buy the option. The maximum loss which can happen to an option buyer is the premium paid . It is because of this reason it is said that option buyer has limited risk.
Example: Suppose you buy a call option at 100 Rs and if market goes against you , the maximum loss will be around 100 Rs because the premium will become close to 0 at expiry.
OPTION SELLER
As an option seller , you collect the premium BUT the risk is unlimited, untill an unless you close the position . The position is open with a liability. If market goes against you , then you have a good amount of risk and to cover this, seller need to have more money / collateral to hold the position. This money which is in the trading account is called as margin.
Example: Suppose you sell a call option at 100 Rs and you will earn once value of 100 decreases . So here the maximum profit will happen if price of the option become close to 0. But what if market goes against you ?
The value of 100 Rs can rise to any value be it 400/500/1000 etc. and hence risk is very high if trader dont close the trade.
Where does this High Margin go when you sell an option?
Now you know that option seller requires high margin not because it is costly but because of the risk involved . When you sell an option , you will see that margin keeps on fluctuating . What does this mean ?
- If market goes against the option seller position, then margin requirements will go high and hence it is recommended that option seller should keep more money (50-60% of trading money ) in his account .
- If market goes in favour of option seller then margin requirement for that trade decreases as well and trader can use it for other trades.
It means that money never come out of trading account but an option seller cant use the margin involved in a trade to sell/buy another trade.
Example
Suppose you want to enter a selling trade and margin requirement is 1 Lac at that time. It doesnt mean that you should have 1 lac only in your trading account because margin might change if market goes against your position . So you should have atleast 1.4 lacs – 2 lacs in your account.
How Margins are calculated ?
Formulae for calculating the margins are usually set by the exchanges and from practicality purpose we will not discuss this in detail. With this article we wanted to explain why option selling is costly and not the formulae for margin calculations.
Key pointes to Remember
- Margin requirement for Option Seller is high because of the risk involved. So a high margin is required which is the money/collateral in the account to hold the position
- Margin money keeps on changing basis price movement . This means money never comes out of traders account but he cannot use the money which is involved in the trade
- An option seller should always keep more than margin money in his trading account than what is required for trade. So if for a particular trade you require 1 lac margin , your trading account should have around 1.5 lacs – 2 lacs.