High Premium Selling: Risk vs Reward Explained | 915

Some traders have the misconception that if they sell a higher-premium option, the profits will also be higher. In the beginning, it might sound logical that if you are selling an expensive option and getting more premium are potential profits may also be larger. However, the deep extra premium is due to the additional risk the trader is taking. It is important for the trader to understand the risk and reward of trading extremely high premium options

Premium is not just income. Premium is compensation for risk.

Why Premiums Increase

Let us look at the chart of an ATM option and compare it with the ITM option.

The current price of Nifty is around 23,134. Hence, the ATM option is a 23,100 call option. For comparison, we will take the 22,500 call option, which is ITM.

Here is the chart of the 23,100 Call option.

As shown in the chart, it is currently trading at ₹238. So what trader who is shorting this call option can make the maximum profit of 238 points in the option.

Here is the chart of the 22,500 Call option -

As shown in the chart, it is currently trading at ₹677. So, what if a trader who is shorting this call option can make a maximum profit of 677 points? There is now a clear difference in the current premiums for both options. 

Moreover, current ATM option premiums are far higher than those last month. Option premiums typically increase when the market expects larger movements. This usually happens when:

• Implied Volatility (IV) rises
• Major events are approaching
• Market uncertainty increases
• Recent price movement has been large

The Hidden Trade-Off

Let's examine both scenarios and check whether traders actually benefit when they short high premiums.

In the case of selling ITM vs ATM, hoping that ITM offers them a high premium and hence high profits. Here is the comparison:

Let us also consider the scenario in which the ATM options are trading at far larger premiums than usual. In this case, when the premiums are high, the risk is also high. The high premiums mean option writers expect large movements, and they want to receive an appropriate premium for the large risk they are taking. This means that high-premium environments often involve:

• Wider price swings
• Faster movement
• Increased chance of stop loss being triggered
• Greater mark-to-market fluctuations

So, while the reward looks larger, the probability of adverse movement also increases. As we saw earlier, the current ATM options are trading at Rs 250. Whereas a lot of times, ATM options only trade at Rs 120. This increase is due to the market pricing in the possibility of a larger move. If the expected movement materialises, the option premium can increase further rather than decay. In such cases, the mark-to-market loss can exceed the premium collected.

High IV Means Higher Uncertainty

Traders should also focus on IV rather than just on premiums. A high premium is often associated with high implied volatility. As can be seen here, the IVs are extremely elevated, reaching around 25 levels. 

In high IV conditions:

• Price movement can be sudden
• Volatility can expand further
• Direction can change quickly

Option sellers benefit when uncertainty decreases. But if uncertainty continues, a high premium alone does not guarantee profit.

When High Premiums Can Be Misleading

Traders should not feel that a high premium gives them free, profitable trades. They should also not feel that if premiums are high, decay will be equally fast, and profits will be easy. In fact, the traders should start thinking in terms of IV and how quick movement can lead to big losses if the decade does not come quickly.

Professional traders focus more on structure than the premium amount. Some of the key considerations include:

• Distance of strike from current price
• Volatility regime
• Event risk
• Position sizing
• Defined risk strategies

Summary

While higher premiums look very lucrative in trading option-writing strategies, they also involve high volatility, which can lead to rapid price movements. The risk increases, and thus the premiums are high to compensate the option writers. Blindly selling options solely because premiums look attractive can lead to inconsistent results. Professional traders evaluate the entire trade environment rather than focusing only on the premium amount.