Investing in the stock market can be a thrilling journey, but for those seeking to add a dash of excitement and potentially boost their returns, exploring options trading might be the answer. One intriguing strategy to consider is “shorting out-of-the-money (OTM) call options” — a technique that can help investors earn extra yield on their existing investments.
What is Shorting an OTM Call Option?
Before diving into the strategy, let’s grasp the basics. A call option gives the holder the right, but not the obligation, to buy a specific stock at a predetermined price (strike price) before the option expires.
An “out-of-the-money” (OTM) call option means the stock price is currently below the option’s strike price.
Shorting an OTM call option involves selling a call option that you don’t own.
The goal is to profit from the decline in the price of the underlying stock or, at the very least, capitalize on the time decay of the option.
How it works?
Imagine you own 100 shares of XYZ Ltd. trading at Rs. 500 per share. You believe the stock is likely to remain relatively stable or even decrease slightly in the short term. To generate extra income, you decide to short OTM call options.
Let’s say you sell 1 XYZ Ltd. call option with a strike price of Rs. 550 for a premium of Rs. 10 per share. This option is considered OTM because the current stock price is Rs. 500, which is below the strike price of Rs. 550.
If the stock price remains below Rs. 550 until the option’s expiration date, the option will expire worthless, and you get to keep the premium collected (Rs. 10 per share, multiplied by 100 shares). This premium serves as the extra yield on your investment.
Downside of Shorting OTM Call Options
While this strategy can enhance returns, it’s crucial to be aware of the risks involved. If the stock price rises significantly above the strike price, you may be obligated to sell your shares at the agreed-upon price. In our example, if XYZ Ltd soars to Rs. 600, you’ll have to sell your shares at Rs. 550, resulting in a loss.
To mitigate this risk, some investors choose strikOTM Call Optionse prices that are a bit higher than the current stock price, allowing for a buffer. However, this may also mean collecting a lower premium.
Read in Detail: An Introduction to Call and Put Options
Time Decay Advantage
One of the key benefits of shorting OTM call options is the time decay factor. Options lose value as they approach their expiration date, especially if the stock price doesn’t move significantly in the desired direction. As time passes, the option premium erodes, and you can buy back the option at a lower price or let it expire worthless.
This time decay can work in your favor, providing an additional source of income on top of any potential capital gains from the underlying stock.
Riding the waves of volatility
Volatility in the stock market can be both a challenge and an opportunity. Shorting OTM call options can be particularly advantageous in periods of low volatility when options premiums tend to be lower. During such times, you can potentially capture more of the premium as time decay works in your favour.
On the flip side, in high-volatility markets, premiums may be higher, offering a tempting yield but also increasing the risk of significant stock price movements.
Shorting OTM call options is a nuanced strategy that adds a layer of complexity to traditional investing. While it can enhance yield and provide a steady stream of income, it requires a careful understanding of market dynamics, risk tolerance, and a keen eye on the underlying stock’s performance.