In the dynamic world of options trading, the term option writer or grantor refers to the party that sells an option contract to the buyer. The act of writing an option allows this individual to collect a premium upfront in exchange for granting the buyer the right (but not the obligation) to buy or sell an underlying asset at an agreed-upon price, known as the strike price, within a specified period.
Types of Options Written
Option writers can create positions in either call options or put options, which may be either covered or uncovered:
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Covered Options: A covered option means that the writer owns the underlying asset that is associated with the option. For instance, if a trader holds 100 shares of a stock, they can write a call option against those shares. This is considered a safer position because the writer can deliver the shares if the option is exercised, thereby limiting potential losses.
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Uncovered or Naked Options: In contrast, an uncovered option (also referred to as a naked option) does not have the underlying asset secured. Writing an uncovered call means the writer does not own the shares they potentially will have to provide if the buyer exercises their option. This strategy carries a much higher risk since the writer can incur significant losses if the market moves unfavorably against them.
The Motivation Behind Writing Options
The primary objective for an option writer is to generate income by collecting premiums when selling options. Key takeaways include:
- Option writers want the options they create to expire worthless and out-of-the-money (OTM). If this occurs, they retain the full premium, leading to a profit.
- In contrast, option buyers seek to have their options expire in-the-money (ITM), as that would allow them to exercise their right and generate a profit from the underlying security.
- The longer timeframe until expiration generally correlates with a higher premium. This situation is due to the greater chance that the option may end up in-the-money.
Risks for Option Writers
When an option writer sells an uncovered call or put, they expose themselves to significant risk. For instance:
- If a call option is written at a strike price of $50, and the underlying stock rises to $80, the option writer needs to buy shares at a market price of $80 to sell them at the exercise price of $50, incurring a loss of $30 per share.
- Meanwhile, the writer has already collected a premium when the option was sold, but it might not offset the loss if the premiums received are less than the loss incurred.
Covered Call Example
Consider an example involving Apple Inc. (AAPL) shares:
- A trader believes Apple's stock will not rise above $220 in two months when the shares trade at $210. They write a call option for $220 at a premium of $3.50.
- If Apple’s share price ends below $220 at expiration, the option expires worthless, and the writer keeps the entire premium of $350.
- If Apple’s price spikes to $230, the writer will have to buy shares at the market price of $230 to sell them at the strike price of $220 unless they already own shares. The situation becomes even more complex when factoring in potential losses.
Covered Put Example
For a covered put writer:
- This involves selling a put option while holding a short position in the stock. If the stock does not drop below the strike price, they keep the premium without any obligation.
- Conversely, if the stock price falls significantly below the strike price, the writer will incur losses offset by their short position in the shares.
Time Value and Premiums
A vital concept for option writers is time value. Time value reflects the premium buyers pay for options that have not yet expired. The longer the duration to expiration, the more potential for price movement, thereby increasing the option's value.
As expiration nears, the time value diminishes—often referred to as time decay. This decay favors option writers, as they benefit when the options they sold expire worthless, allowing them to keep the entire premium.
An example illustrates this concept: - An option trading at $5 might be out-of-the-money and have no intrinsic value. If the option remains out-of-the-money till expiration, the seller retains the full $5 premium, allowing them to profit without incurring a loss.
Conclusion
Understanding the role of an option writer is crucial for anyone looking to delve into the complex world of options trading. Writers can generate income from premiums, especially through covered strategies, which mitigate some risks associated with naked options. However, the potential for loss can be substantial when trading uncovered options, making risk management an essential part of the strategic approach in this domain.