InvestorQ : I am not clear how volatility works against me in selling options if price does not move?
Dia Deshpande made post

I am not clear how volatility works against me in selling options if price does not move?

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Ria Jain answered.
2 years ago

When you buy options, volatility works in your favour. However, when you sell options the volatility of the stock works against you! Let us understand this point in greater detail. Let us go back to the Rs.320 call option on SBI which you written at Rs.5. Let us say that the price of SBI has gone up to Rs.340. Theoretically, your loss should be Rs.15 after considering the Rs.5 you received on the option. But then options trade at a price which is (intrinsic value + time value). So when SBI touches Rs.340, the 320 call option will not trade at Rs.20 but at a higher level of say Rs.25. Therefore your notional loss will be Rs.20 and not Rs.15. This becomes critical when you have to report your MTM on a daily basis.

Higher initial Margin risk

When you buy options, you pay premium margins. That is because your maximum loss on the trade is limited to the premium paid. But when you sell options your losses are unlimited just like a long or short futures position. Hence your initial margining will be exactly like in case of futures when you write options. You will be charged the (SPAN margin + exposure margin) as part of your initial margin when you sell options. You need to factor in the financial cost of margins when you write options and ensure that your option premium earning covers that cost.

The risk of mark to market margins

The other margin that you need to pay apart from initial margins is the MTM margins when the price movement goes against during the month. Normally, when your total margin including MTM goes below the maintenance margin, the broker will make a margin call on you. This is again a risk you need to be prepared for if you sell options.

Assignment was a risk, but that is no longer the case with European options

In the past, stock options in India used to be American options and index options were European options. American options could be exercised at any time before expiry and hence when an option was exercised, it had to be assigned at random to a writer of the option. That was another risk for the option write. However, stocks have also shifted to European style options and hence that risk is not there any longer.