Even though I prefer to invest in companies after lot of research, eventually I am in this market to make money. So it really does not make any investment sense to put restrictions like only generate returns by investing long term in the market. In fact I have figured out a way to generate some very handsome short term returns by effectively using index options without sacrificing by long term goal of good returns from stocks. (I have not applied for patent for this strategy yet :-) since it is a very common strategy used by many people)
And the returns are pretty handsome anywhere between 35% and 60% per annum depending on your risk profile. And more over this will come as a byproduct of your existing investment in stocks which will eventually add up to the returns that your stocks make.
Now before I discuss this strategy I would advise you to read my Disclaimer. This is because what I will be discussing now will qualify has a high risk strategy for some people. My risk profile is above average and all my strategies are aligned towards that risk strategy. So this goes as a special note of caution. Please do not follow this option strategy if you are not aware of the basic concepts of option trading. This strategy will expose you to very high risk some times. And at least once or twice in a year you are likely to face huge losses if market moves in one direction strongly (Like a Black Friday, or a golden Monday etc).
This article assumes that you are you are aware of the basic concepts of futures and options. This article is not a refresher to Futures & Options strategy.
A strategy where you can make unlimited loss and limited profits!!
Yes this strategy is all about selling options where theoretically you can make unlimited loss and limited profits. I know half of the people will stop reading this ridiculous post after the first line after all who wants to hear a strategy where your profits if any are limited and loss is unlimited. And moreover what is this all about selling of options, we as a conservative investors know only to buy options as a protection against market volatility and play safe.
Most of the investors think the same about options. These are safe way to play the market you pay a premium to buy a call or put option depending on the market conditions and make money from favorable market movements.
However how many of us including me has lost the money while buying options due to any of the following condition.
- My option simply expired as the market did not move as expected
- My option expired since market moved in the opposite direction.
- Market moved in the direction as I expected still I made a loss as the premium I paid for the options was high.
Options are very brutal instruments where the time plays a key factor in deciding the value of options. We call it time decay. Time decay can destroy the value of your options under the following conditions even if the market moves against you but not in the same pace.
Confused!! No problem I have illustrations please be patient.
Now what if we can make this time decay favorably on our side and make some profits instead.
The Strategy
Simple sell far out of money call / put options and pocket the premium in advance and wait for the time decay :-)
All of us know for buying the options we need to pay a premium and the seller of the options will get the premium upfront and will assume all the risk in case the buyer wishes to exercise the option in his favor. This is what I meant by unlimited risk earlier.
So what if there is any option which I can sell where there is very less chance of getting exercised? In that case I can pocket my premium upfront and wait for that option to expire.
However the key to this strategy to workout properly is the timing of selling the options. This timing can determine at the end how much you make as profits every month.
Sell Call Option when market is going up and Put option when it is going down
The idea behind this strategy is to capitalize on the market fatigue after it has made a move. Market will always over react on its way up and way down. You can find instances of this over reaction every monthJ. For example in the first half of this month the market was about to touch 5300 and most of the people in the market were predicting 5500 by the end of January. You open CNBC and you will be flooded with analysts who were predicting a level of 5500 as an immediate target for Nifty. The most surprising fact is that even though the markets were rising steadily for last two months from 4700 to 5000 to 5250 many people simply forgot the basic principles of life – “What goes up will come down”. You throw a stone up, depending on the speed that you throw it will go up initially covering more distance with less time and slowly the fatigue starts kicking in the speed reduces and there will be a position where it is in no position to go up and the only way is to go down. This is the same case with the market. When markets where at 5300 people were expecting it go to 5500 so the best thing to do over here is sell the 5600 call option and pocket the premium (say 50Rs).
If you have sold the Jan 5500 call which was quoting at around 50Rs during Dec the current price for that is around 0.6Rs (yes 60 paisa). You do not need to cover it even now just wait for 2 more days it will expire (means the price will reach zero).
The same is applicable for put options also. In just 3 days the market has retraced from 5270 to 5000 now. If you see 4500 Feb put option it is trading at around 25Rs. If you believe that the market can go down but not to 4500 in Feb then you can sell this option and pocket the premium.
Biggest margin of safety while selling Call options
I like selling call options than put options. One of the main reasons behind this is that there is very little chance of making absolute loss if you follow some steps.
- Always keep the margin for selling call options as stocks and not as cash
Normally for selling one lot option the retail margin is anywhere between 17000 to
20000Rs. And this can vary from broker to broker. Most of the brokers will have an option
to keep this margin either as cash or as pledge of equal value of stocks. So in worst case
scenario even if the market rises to your option level your stock price will also rise (the price of the pledged shares)
- Your pledge stock price also rises with the market giving you more room to sell options at higher levels.
Finally
So that’s all about this strategy as of now. I am thinking of a section where I can discuss every month which option are sellable from my point of view. Let me know what you think of this so that I can plan for this.
So for me this is just a way to maximize the returns of the stocks which I hold for long term where I pledge those shares create margin money and use that margin to sell the options. A simple calculation shows the returns from this strategy anywhere between 55-60% per annum if you execute these trades smartly. And more importantly never try this strategy in stock options as there will always be a stock specific risk
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