Beware !!! Option Sellers
OTM Option selling is being heavily promoted these days as if its a common man's tool to make consistent 1% or so returns every week. This extrapolates to around 48% return per year which seems very attractive. OTM option selling does have high accuracy and small profits can be made consistently. It is therefore very easy to have a sense of confidence on a selling strategy. But this is just false confidence as one black swan day is enough to wipe out everything or most of the profits.
If you are an option seller there are things you should know. Here we list those things so that you are not taken back when lightening does strike as it inevitably will one day or the other.
- A naked sell position has infinite risk. If market moves against the short position you can loose any amount of capital in proportion to the movement. You can certainly hedge the naked sell with long option. But even if this hedge is with an option strike 150 points away the max loss is around 15% on capital. This means the strategy needs to be more than 94% accurate to just break even if you account for the black swan day effect.
- When you sell an option a margin amount is blocked by the exchange which is not constant. It varies dynamically as per underlying market price, volatility of underlying instrument, time to expiration etc. This implies that under dynamic market conditions the margin requirements can change pretty fast and probably exceed your account funds. This leads to margin shortfall and a margin penalty is booked against your account. Your position may even be auto squared off by the RMS team of the stock broker. This is true for both naked sell and hedged sell positions.
- As market moves against your position continuous adjustments and firefighting needs to be done. This would need on your side pretty decent discretionary skills and time investment. It's not super simple or a passive activity by any stretch of the imagination. Also, trading is a business and need us to estimate and keep a certain capital. The discretionary nature of option selling firefighting means we cannot really estimate an exact capital required for the trading activity.
- Far OTM strikes are not very liquid. As your position size needs to be large to generate a fair profit, it becomes that much more difficult to enter or exit positions with illiquid options. We have to place limit orders and then continuously keep monitoring and adjusting it with fast moving market to get appropriate order fills. This again needs significant time investment with each order we place.
- Options prices can move wildly especially at market open. Overnight stops can get taken out pretty easily during these wild swings before market settles. Note that NSE has removed trade execution ranges for options. Think twice before you deploy stops with OTM options.
- As per the prevailing margin rules it is possible to get margin benefit if you first buy an option and then sell another option. However some brokers like Zerodha doesn't allow to buy deep OTM options. If you are trading with such a broker you will have to give away that benefit when we enter positions. This means you need more funds in our account.
- With a stock broker with Rs.X per order flat fee, a one legged naked option selling will cost Rs.2X per trade (entry + exit) as brokerage. A two legged hedged strategy like a calendar spread will cost Rs.4X brokerage. An Iron Condor like 4 leg strategy will cost 8X brokerage. This is without taking into account the brokerage cost for adjustments, firefighting, profit booking etc. Thus there is a cost angle to a sell strategy which needs bit of consideration especially if you trade with a % broker or if your positions size is small. The minuscule profits could be easily eaten away by brokerage.