In the insurance business model, cash comes upfront and is invested; claims are paid as and when they arise. By underwriting risk and collecting a premium for doing that and investing the same to generate investment income, an insurance company can make an underwriting profit as long as the premiums collected are higher than the claims paid and expenses incurred.
The other option
It is also possible to generate income over and above capital gains and dividends by selling options with the underlying being an index or a stock or a basket of stocks. Selling options entitles an investor to collect premium for assuming the risk that the underlying will carry in a particular way. This is a zero-sum game, and at expiry, someone always wins and someone else loses.
Historical data shows investors who sell options tend to do better than those who buy them. As long as the risk is well understood and, more importantly, well managed, selling options can be an income-generating strategy with the possibility of infinite return, as investors can use existing investments as margin to assume the risk and generate income without making any investment commitment.
How to generate income from options?
With a demat account, one can sell options by using existing investments as margins. One needs to decide the contours of the option trade like what will be the underlying (say Nifty), what will be duration of the contract (typically monthly), at which strike price to assume risk (can be near or far from the current spot) and whether to sell only Calls or only Puts or both Calls and Puts.
Selling a Call implies that the investor believes the underlying will not go above a pre-determined threshold; selling a Put is the opposite and reflects the option seller’s view that the underlying will not fall below a pre-determined threshold.
Option sellers earn a premium for assuming the risk when the underlying behaves in line with the investor’s view. If the underlying trades rangebound, the investor gets to earn the premium.
If the underlying trades outside the range, the investor can incur a loss and that loss is calculated depending on how far has the underlying moved from the strike price that the investor chose when s/he agreed to underwrite the risk adjusted for the premium collected.
One key feature of all derivative markets is the implicit use of leverage. In a normal cash market, if an investor buys shares worth Rs 1 lakh, s/he has to pay Rs 1 lakh and the shares are delivered into the investor’s demat account. The ownership of such shares would allow the investor to receive dividends from the company, and exercise a vote on how the company’s affairs are run.
However, with any derivative contract – including when options are sold — the investor is able to underwrite the risk assuming a notional value, which is the multiple of the margin that the investor gives to his/her broker.
To that extent, gains are limited while losses can be magnified. It is important for the investor that s/he chooses an adviser and broker, who has experience in this field and is able to advise the investor in terms of the risk that the investor should assume.
From the market’s perspective, derivatives can help create much higher liquidity in the underlying asset. They will also allow the investor to take larger positions than their cash holdings permit. Here, it is important to note that since derivatives are leveraged products, one has to usually pay interest or cost of carry for the value of their notional investment.
Since the derivatives market is very liquid, the cost of carry or interest cost is usually significantly lower than what one has to pay to post cash margin/borrow and provide margin.
Among the many instruments available in the derivative market such as forwards, futures, options and swaps, the most commonly deployed derivative instruments are futures and options. In India, exchange-settled derivatives are regulated by Sebi.
(Sameer Kaul is the Managing Director and CEO of TrustPlutus Wealth Managers (India). Views are his own)