An option writer is the party in an options contract who sells the option to a buyer and, in return, collects the premium payment. By writing an option, the seller incurs an obligation to either deliver or receive the underlying asset if the option is exercised by the buyer. The writer can either be long (holding the underlying asset) or short (not holding the underlying asset). This distinction significantly affects the risk and reward profile of the strategies involved.
Types of Option Writers
Covered Option Writer
A covered option writer holds the underlying asset against which the option is written. This strategy reduces the risk associated with writing options, as the writer already owns the asset they might have to deliver.
Naked (Uncovered) Option Writer
A naked option writer does not hold the underlying asset. Writing naked options can be highly risky since the writer may have to procure the asset at unfavorable prices if the option is exercised.
Long and Short Strategies of Option Writing
Long Writing Strategy
Overview
In a long writing strategy, the writer sells a put or call option while holding the underlying asset. This approach is primarily used to generate additional income from assets already held within a portfolio.
Benefits
- Income Generation: Collecting premiums from option sales.
- Downside Protection: Mitigates potential losses if market prices decline when covered calls are written.
Risks
- Limited Upside: Caps the potential profit if the asset’s price increases significantly.
- Opportunity Costs: Assets are tied up and cannot be sold easily.
Short Writing Strategy
Overview
In a short writing strategy, the writer sells options without holding the underlying asset, also known as selling naked options. This is considered speculative and high-risk, often used by more experienced traders.
Benefits
- Premium Collection: Immediate income from the sale of options.
- Market Neutrality: Can be profitable in a range-centric market.
Risks
- Unlimited Loss Potential: Especially true for uncovered call options.
- Margin Requirements: Higher capital needed to cover potential losses.
Special Considerations
Margin Requirements
When writing options, especially naked ones, brokers typically require higher margins to cover potential losses due to the associated high risk.
Regulatory Implications
Regulations and rules about option trading can vary by exchanges and jurisdictions. It’s essential to be aware of and comply with these rules.
Examples
Covered Call Strategy:
A trader holds 100 shares of Company XYZ and writes a call option with a strike price higher than the current market price, collecting a premium for the obligation to sell the shares if the option is exercised.
Naked Put Strategy:
A trader writes a put option for Company ABC without owning the underlying asset, aiming to collect the premium. If the option is exercised, the writer must purchase the shares at the strike price, potentially facing significant losses if the market price is much lower.
Historical Context
The practice of writing options dates back to the early 17th century in the Dutch market with the trading of tulip bulbs which served as underlying assets. Modern option writing became more structured with the establishment of the Chicago Board Options Exchange (CBOE) in 1973, providing a standardized trading floor for options.
Applicability
Option writing is utilized in various financial contexts, including hedging, income generation, and speculative trading. It’s particularly prevalent among institutional investors, fund managers, and experienced individual traders.
Comparisons
Writer vs. Buyer
Unlike the option writer, the buyer pays the premium for the right (not the obligation) to buy or sell the underlying asset.
Long Writing vs. Short Writing
Long writing involves holding the asset, reducing risk. In contrast, short writing is higher-risk due to potential significant losses if the market moves against the writer.
Related Terms
- Premium: The price paid by the buyer to the writer for the option.
- Strike Price: The price at which the underlying asset will be bought or sold if the option is exercised.
- Expiration Date: The date on which the option contract expires.
FAQs
What is the primary benefit of being an option writer?
How risky is writing naked options?
Can anyone become an option writer?
References
- Hull, J. C. (2017). Options, Futures, and Other Derivatives. Pearson.
- Chance, D. M. (2008). Analysis of Derivatives for the CFA Program. CFA Institute.
Summary
Option writing is a sophisticated trading strategy that involves selling options to collect premiums but comes with varying risk levels depending on whether the options are covered or naked. By understanding the mechanisms, strategies, and potential pitfalls, traders can decide on the best approach for their financial objectives and risk tolerance.
