Should You Buy Or Sell Options?

A word of caution at the outset - trading options is an activity that's fraught with risk, and things can go horribly wrong in a very short time! This article isn't meant to be a lesson in option trading, but rather to serve as a simple decision making framework for those that are relatively new to option trading and are looking for an answer to the question: should you buy or sell options?

The answer lies in a combination of two factors: your trading mindset, and your trading outlook. An illustrative example will help you understand this better.

But first, a short note on trading itself. Any trading activity (not to be confused with 'investing') involves making a best guess on the future value of an underlying asset - be in gold, cotton, a specific stock, or an index. Your best guess may be based on hearsay (an exponentially riskier strategy!) or a model that you've tested and fine-tuned over the years (a better way to go). Either way, you're making a punt on the price of something, based on where you think it's headed within a specific time frame. Your time frame could be a few minutes (if you're a scalper), a few hours (day trader), a few days (swing trader) or even a few weeks (position trader). But the underlying dynamics do not change, regardless of the time frame chosen by you.

Back to the example, now. The NIFTY stands at 9,400 today. Assuming you are bullish on the NIFTY for the next ten days (you could just as well be bearish - that's what makes trading a great big zero sum game), you've got two basic options - no pun intended - regarding how you can use options to cash in on this predicted short term swing - you can either buy a call or sell a put. Let's understand the dynamics of both.

The price of a 9500 NIFTY Call Option (25th May expiry) is Rs 30.55. However, bear in mind that on 25th May, the 9500 Call Option will only have any value if the index closes above 9500. For instance, if you buy the Call Option today, and the NIFTY closes at 9600 on 25th May, you'll gain roughly Rs 70 - because the Option that you paid Rs 30.55 for, would be priced at Rs. 100 (9600-9400). However, you'll be losing money at any index closing level that's below 9530.55. To that effect, the "time value" of Rs. 30.55 will be your handicap.

Another trading opportunity exists, in the form of selling or "writing" a Put Option. The price of a 9400 NIFTY Put Option (25th May Expiry) is Rs 56 today. However, the "intrinsic value" of the Put Option is really Rs 0 (9400 minus 9400), which means that if you sell the Put Option today and the index doesn't move at all till the 25th May, you'll still profit by Rs 56. To that effect, the "time value" of Rs. 56 is like your "insurance" against your bullish call going wrong. For longer duration expiries (say the June expiry) you'll find that this "insurance" is a lot higher, giving you a much wider margin of error to work with.

Which strategy should you go with? First, it would depend on just how bullish you are. If you're certain that the NIFTY will close significantly higher than 9530.55 on the 25th May, the Call Option would make sense for you, despite the Rs. 30 handicap - as your potential upside beyond that level is unlimited. If on the other hand, you're just semi-bullish or expect the index to remain more or less flattish, with an upward bias, pocketing the premium of Rs. 56 and waiting for the index to close at or slightly above 9400 (rendering the Put Option valueless) would make more sense.

Your individual trading mindset also counts. Does the potential margin of error of Rs 56 appeal to you more (despite the higher margin requirement and the prospect of unlimited losses if the index were to crash in the next ten days) - or does the prospect of unlimited profits, despite the handicap of Rs 30 appeal to you more? Ultimately, a lot of trading success is dependent upon whether or not the trader's strategy is aligned with his or her temperament. Only introspection - and experience will reveal what's your best fitment.

Over time, you'll discover that you're cut out for one of the two strategies, but not both. Once you've made that discovery, stick with it and fine tune your strategy. The best traders in the world are highly self-aware and highly disciplined. For more on trading, I strongly recommend a book called "Stock Market Wizards" by Jack Schwager. It'll give you some keen insights into the small universe of consistently successful traders, their struggles, and their collective modus operandi.