Basically, Option Buying happens when an investor expects the price of a Share to increase. Whereas Option Selling happens when he expects price of the share to fall. So here comes the first question “How can I sell something that I don’t own at all?”.
Example of Option Selling
Lets say you are an expert in Apples. You know everything about their Yield, Quality, Demand etc. You know when does the price of Apples fall and When does it’s priced shoot up.
Now a Big Super Market approached me to sell them 10,000 Apples at Rs.50 per apple. They asked you to deliver the apples one month from now. Now, I don’t have apples with me. My Warehouse is empty. I’m repeating, I don’t have any apples today with me.
But I know in a month’s time, the price of Apples is going to fall. So what do I do. Even though I don’t have any apples, I take money from the supermarket, that is Rs.50,000 and Complete the sale.
After one month, as I expected, price of each Apple fell to Rs.40. Now I have to make the ‘Delivery’ to the Supermarket. I buy 10,000 apples paying Rs.40,000 and finish the DELIVERY. Now if you see clearly, I made a profit of Rs.10,000.
First I sold at Rs.50 per apple and one month later I bought it for Rs.40. This happened only because I am an expert and I knew price of apple will fall. If I expected price of apple will increase, I would not have made this Sale Transaction. So this is nothing but Option Selling.
Imagine there’s a company whose share is trading at Rs.50 today. And I’m an expert in stock markets and I know price of this share will fall within one month. So what do I do? I will SELL 10,000 Delivery shares, which means I received Rs.50,000.
Now because I sold something that I don’t own, my Account shows holding balance of (-10,000). One month later, say share price fell to Rs.40. Now I have to Deliver the shares, so I pay Rs.40,000 and buy 10,000 shares. Now my negative (-10,000) quantity has become Zero because I bought back the shares. Which means it’s squared off.
When I sold the shares, I got Rs.50,000. When I bought the same shares after one month, i only paid Rs.40,000. Which means I made a profit of Rs.10,000 from this Option Selling transaction.