Can Options Selling Become a Source of Fixed Income?
The Indian stock markets have always had a strong negative bias against multivariate products, owing to the apparent complexity. Futures and Options (F&O) or derivatives is one segment that demands a nuanced approach and hence is famously infamous in its own way. You will notice the TV anchor or that uncle warning you, every time you contemplate trading the F&O market.
The second bit is fixed income. Fixed income in India is a fairly celebrated concept and widely recommended too. Having said that, the ways via which people pursue fixed income have kept on evolving. Through this piece, I would like to propagate another idea that can be a pertinent source of fixed income.
Now, buying options is more spoken of, perhaps because of the directional clarity. What I mean is, when you buy a call option you make money if the price of the underlying asset goes up. However, when you sell a call option you make money if the price does not move. So, selling options is not the opposite of buying them, a general misconception.
Let us understand this through a comprehensive example. The strategy is to sell a 10% Out-of-The-Money (OTM) index call and put option (CE & PE respectively) on the 1st trading day of every month. In other words, the index has to move 10% (either on the upside/downside) for you to incur losses. When you sell options, you receive premiums against them, which is your maximum profit. If the option expires worthless, you get to keep the entire premium amount.
On May 3rd (the first trading day of this month) Nifty50 was trading at 14,619. Therefore, I would sell a CE with a strike price of 16,100 (14,619*1.10) and a PE with a strike price of 13,150 (14,619*0.90). The numbers are adjusted to the nearest 50. The premiums would be-
CE: 13*50= ₹650; PE: 40.96*50= ₹2,048 (50 is the lot size).
The assumed capital is ₹1,00,000. Now, let us look at the probability of the index moving 10% on a given month. For this, we shall take 13 months’ worth of data, i.e. from April 1, 2020, to April 1, 2021. When worked out it is to be found that out of the 13 months, the index has made a 10% move only once. That means if you took this trade over the course of these 13 months (26 contracts), 25 of them would expire worthless. Another assumption is that as soon as a 7% move is made, I would square off my position. The google sheet explains the calculations.
In totality, the inflow would be that of ₹35,074 and outflow of ₹22,650. Hence, this trade would fetch you a return of 12.42% on an annual basis. The question is would you take the trade? Now, there are a lot of fixed income products in the markets that offer returns in the range of 6–9% but the problem is their rigidity. And, rigidity is a destroyer of modern attention. They come along with a bunch of complications such as an exit fee or lock-in periods and so on. Having said that, it does not mean that the above strategy is infallible.
The idea behind outlining this trade is to throw light on a simple strategy that many active market participants overlook. Another major reason behind this activity is to contest a common conception. The majority of us believe that fixed income must be looked at only when nearing retirement. In my opinion, that is incorrect and it should be an active source of income for every career stage. New ways crystallize old concepts.
