Combat rise in margin by writing with protection

They say over 60 percent of Options ever created have expired worthless. Well, the number may be bigger. That is the very reason why we Write (Sell) Options. However, the ongoing changes with the expected rise in the margin could impact the returns.

While we get excited by the amount of success in writing trades, we need to remember that selling options come with limited profit only. That is why any increase in margin will increase the investment amount directly. With the addition of the trad, we can solve this problem and a few others as well.

What is Writing with Protection?

Buying a Call against a Call sold and a Put against a Put sold means buying protection. Simply put, we need to have an equal number of Buy and Sell positions in Options to establish writing with protection.

How to execute this?

For every Call or Put option sold, we need to buy a Higher Strike Call or a Lower Strike Put which is about 2-3 steps higher or lower than the Call or Put sold.

What is the Impact?

1. The option selected to be bought for protection here will always be cheaper than the option sold. So, there will be premium credit in the trade. However, the premium credit will be lower.

2. Although the premium credit is lower, the potential loss due to option buy is also lower and more importantly limited to difference between bought and sold option strike minus the premium credit.

3. There will also be reduction in margin requirements now as the exchange will also appreciate the limited loss characteristic of the protected option writing trade.

Let us talk about benefits now

1. Biggest benefit is the reduction in Margin in a protection trade is generally proportionately bigger than proportionate drop in premium credit.

Example:

Writing without Protection: Premium Credit = 100, Margin = 10000

Writing with Protection: Premium Credit = 50, Margin = 3000

2. Options have an inherent nature of moving at a faster speed if there is favourable direction (Up for Call and Down for Puts). Being sellers or writers of the options, we will be adding up losses faster if up move happens after Call sell or down move happens after Put sell.

Protected writing will minimize this faster speed of losses by a significant amount. This is because the bought option would be making money for us at more or less the same speed as the speed at which the sold option could give us losses.

3. Last but not least, remember limited especially known loss and lower margin requirements. This will help us create more positions for a given capital. Taking the example in the 1st point for 10k Capital now we will be able to do 3 trades of Protected writing with 3k margin requirement. The inflow here will be 150 which is 50%higher than the traditional writing.

Protected writing thus, is more of “have your cake and eat it too” kind strategy.