In options trading, "shorting," or "writing," typically refer to the same concept. In simple terms, option writing involves selling an options contract, which obligates the seller (writer) to fulfill certain conditions if the buyer (holder) exercises their right under the contract. This action creates the possibility of earning a premium, which is the fee paid by the buyer. However, it also exposes the seller to significant risk, particularly if the market moves unfavorably.
In this explanation, we’ll delve deeper into the following areas:
Basics of Options Contracts
Types of Options: Calls and Puts
What is Writing an Option?
Risks and Rewards of Writing Options
Covered vs. Naked Option Writing
When Do Traders Write Options?
Real-World Example
Final Considerations
1. Basics of options contracts
An options contract is a financial derivative that gives the buyer the right, but not the obligation, to buy (for a call option) or sell (for a put option) an underlying asset (such as a stock) at a specified price, known as the strike price, before a specific expiration date.
Call option: Allows the buyer to purchase the asset at the strike price.
Put option: Allows the buyer to sell the asset at the strike price.
Each options contract typically represents 100 shares of the underlying asset.
2. Types of options: calls and puts
In options trading, there are two types of contracts, each of which can be either bought or written (sold):
Call options:
A call option gives the holder the right to buy the underlying asset at the strike price. If you write (sell) a call, you are betting that the asset’s price will not rise above the strike price before the option expires.
Put options:
A put option gives the holder the right to sell the underlying asset at the strike price. When you write a put option, you are betting that the asset’s price will not fall below the strike price before expiration.
3. What is Writing an Option?
Writing an option refers to creating and selling an options contract to a buyer. In this scenario, you are the seller (or writer), and you will receive a premium upfront from the buyer. In return, you take on an obligation to either sell or buy the underlying asset if the buyer exercises their option.
Writing a Call Option:
If you write a call option, you are obligated to sell the underlying asset at the strike price if the buyer chooses to exercise the option. This occurs if the market price of the asset is higher than the strike price, as the buyer would want to purchase the asset at a lower price.
Writing a put option:
If you write a put option, you are obligated to buy the underlying asset at the strike price if the buyer exercises the option. This typically happens if the market price of the asset is lower than the strike price, as the buyer would want to sell at a higher price.
4. Risks and rewards of writing options
The primary incentive for writing options is earning the premium. As the writer, you collect this premium as income, and you keep it regardless of what happens in the market. If the option expires worthless (i.e., the buyer doesn’t exercise it), you keep the entire premium without having to fulfill the contract. However, this premium comes with the risk of potential loss.
Maximum profit: The most you can earn from writing an option is the premium you receive when selling the contract. Unlike buying an option, where the upside can be significant, writing limits your potential profit to the premium.
Maximum loss: The loss you may incur depends on whether you're writing covered or naked options (explained later). In the case of naked call writing, the potential loss is theoretically unlimited if the underlying asset's price skyrockets. For naked put writing, the maximum loss is significant if the asset’s price falls sharply, though it's typically capped because the asset can't fall below zero.
5. Covered vs. naked option writing
There are two main types of option writing:
Covered option writing:
When you write a covered call or covered put, you already own the corresponding asset (or have sufficient funds). For example, in a covered call, you own the stock that you may have to sell. Covered writing reduces risk because you are ready to fulfill the contract with the assets you already possess.
Naked option writing:
In naked writing, you don't own the underlying asset or don’t have sufficient funds set aside. This strategy carries far more risk. For example, if you write a naked call and the stock's price soars, you may need to buy the stock at a much higher price to sell it at the strike price, resulting in massive losses.
6. When Do Traders Write Options?
Traders generally write options for one of the following reasons:
Earning income:
Writing options can generate a steady income through the premiums. If the option expires worthless, the writer keeps the premium without any further obligation. Traders who expect minimal price movement (i.e., low volatility) often write options, hoping the option will expire without being exercised.
Neutral or mildly bullish/bearish outlook:
Writers typically adopt this strategy when they don’t expect significant price changes in the underlying asset. For example, writing a call is more common when a trader expects the asset to remain below the strike price, while writing a put is common when expecting the asset to stay above the strike price.
Speculation on low volatility:
Traders can sell options to bet on low volatility. When volatility is expected to be low, options tend to lose value over time due to time decay (the gradual reduction in the option’s value as the expiration date approaches). The writer profits if time decay erodes the option's value faster than the price movement of the underlying asset.
7. Real-world example
Imagine you're a trader who owns 100 shares of stock XYZ, which currently trades at Rs.50 per share. You don't expect the stock to rise significantly over the next few months, so you decide to write a covered call option with a strike price of Rs.55 and an expiration date 60 days away. You receive a Rs.2 premium per share, earning Rs.200 (since 1 option contract = 100 shares).
Two scenarios can unfold:
If XYZ stays below Rs.55 until expiration, the option expires worthless. You keep the premium (Rs.200) and your stock.
If XYZ rises above Rs.55, the buyer exercises the option. You sell your shares at Rs.55, plus you keep the premium. Even though you missed out on any gains above Rs.55, you've still profited from the stock's rise and the premium received.
8. Final considerations
Option writing can be a lucrative strategy for traders seeking to generate income, but it also carries significant risk, particularly with naked writing. Before engaging in option writing, it’s crucial to understand the potential liabilities, particularly in volatile markets.
Experience level: Writing options is typically recommended for more advanced traders, as it involves higher risks compared to simply buying options.
Risk management: Traders should always employ risk management strategies, such as setting aside sufficient capital or owning the underlying asset (covered writing), to minimize potential losses.
In conclusion, writing options is a strategy that allows traders to earn income through premiums, but it demands a thorough understanding of market dynamics and risk exposure. With careful planning, it can be an effective component of a broader investment or trading strategy.
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