What is an option writer?

In futures trading, an option writer (or seller) is the market participant who creates and sells an options contract and receives the option premium. Writers take on the obligation to buy or sell the underlying if the option is exercised. To qualify as a writer, one must be a market participant who is willing and able to take on the risk of selling options contracts.

Option writers need sufficient capital, sufficient understanding of the options market, including options type, mechanics, and the willingness to accept the additional downside risk of potential unlimited loss in options trading. 

How writing option contracts works 

Options writing is when one person creates (sells) an options contract with another person. The contract grants the buyer the right, but not the obligation, to purchase or sell a set quantity of the underlying at the strike price by or at expiration. The writer of the contract collects a premium (charged per share) for the cost of the option immediately. The writer of the contract takes on a potential obligation if the buyer decides to exercise the option. 

Types of option contracts for writing

There are two types: call options and put options. If someone sells a call option, they are obligated to sell the underlying at the strike price if the buyer exercises. If they sell a put option, they are obligated to buy the underlying at the strike price if the buyer exercises.

The strike price is crucial because it determines the value of the option and the possible gain for the trader.

Call writing vs. put writing

A call option grants a buyer the right, but not the obligation, to purchase an underlying asset at a predetermined price before a set future expiration date. The underlying assets can take the form of bonds, stocks, and other securities, particularly if the stock price stays stable.

A put option grants the buyer the right, but not the obligation, to sell the asset at a preset price on a specific date. In both cases, the option writer receives premium and takes on the obligation to fulfil the contract (sell on a call, buy on a put) if the buyer chooses to exercise.

How call options work in financial markets

Call options can be compared to a wager between two investors: one investor believes the underlying asset price will increase while the other thinks it will decrease, making it essential to consider various option strategies.

The basic features of a call option are:

• Underlying asset: The asset on which the option is based, such as a stock, bond, or commodity. This is sometimes referred to as ‘the underlying’.
• Strike price: The predetermined price at which the buyer can purchase the asset if they choose to exercise the option.
• Expiration date (Expiry): The date by which the buyer must choose whether to exercise the option or let it expire.
• Premium: The fee paid by the option buyer to the seller.

The two main players in a call options contract are the buyer and the seller:

• Call option buyers: Pay a premium for the right, but not the obligation, to purchase the underlying at the strike price before expiration. Their risk is limited to the premium paid, but their profit potential is theoretically unlimited if the asset price rises above the strike price.
• Call option sellers: Receive a premium in exchange for the obligation to sell the asset at the strike price if the call buyer chooses to exercise the option. Their profit is limited to the premium they receive, but their risk is theoretically unlimited if the asset’s price increases significantly above the strike price and the seller doesn’t already hold the underlying shares (also referred to as selling a ‘naked’ call).

If the underlying asset market price increases above the strike price, the buyer can exercise the option or sell it at a higher market value. If the asset price falls below the strike price, the option expires, and the buyer loses only the premium paid.

A call option can be said to be in the money, at the money, or out of the money. When the underlying asset is trading above the strike price, it’s considered to be ‘in the money’. This means the option has intrinsic value. When the underlying asset is trading at the strike price, the option is ‘at the money’. This means it has no intrinsic value but could still hold time. When the asset price is below the strike price, the option is ‘out of the money’. In this case, the option has no intrinsic value, and the contract expires worthless.

Most call options use one of two expiration rules, known as American and European options:

• American options: Can be exercised at any time before expiration. This gives more flexibility if an option is in the money before expiration, and the holder has cash-flow or inventory preferences.
• European options: Can only be exercised on the expiration date. This means the underlying asset can only be delivered at the end of the options’ life.

Despite their names, American and European options refer to exercise rules rather than geographical location. Both types are traded globally and subject to the same pricing principles.

Call option example

A buyer can purchase a call option to have the right to buy 100 shares for $50 each (the strike price) until the option’s expiration date. In this case, the buyer hopes the price of the underlying stock will increase to above $50.

Say the stock price increases to $55. The buyer can choose to exercise the call option for $50 and gain $5 per share – that’s a total return of $500. However, the buyer must still pay the seller a premium. If the premium was $3 per share, then the call option costs $300 for the 100 shares, meaning the buyer’s net return is $200.

This example doesn’t account for any additional commissions, fees, or tax implications, which can significantly impact net returns.

How put options work in financial markets

The basic features of a put option are:

• Underlying asset: The asset on which the option is based, such as a stock, bond, or commodity.
• Strike price: The predetermined price at which the buyer can sell the asset if they choose to exercise the option.
• Expiration date (Expiry): The date by which the buyer must choose whether to exercise the option or let it expire.
• Premium: The fee paid by the option buyer to the seller.

Put options can also be American or European, with the same rules and principles as call options.

The writer sells the chance to purchase a set amount of the underlying in the future. They want to find a buyer who will pay a premium for that chance. They open a position on the market, hoping to find an interested buyer.

The market finds a buyer for the seller. The seller's gain in this situation would be limited to the entire premium paid, and they are at a higher risk of loss from options trading should the price of the underlying drop below the option strike price.

The buyer of a put option pays the premium for the right to make the transaction. If the underlying price falls below the strike, the put gains intrinsic value and the buyer can profit. If the underlying price stays above the strike, the put will likely expire worthless and the buyer’s loss is limited to the premium paid.

Advantages of being an options writer

There are some benefits and associated risks for writers, including:

• Additional income with upfront payment of premiums
• Retaining the complete premium collected if the option expires worthless
• Time decay works in the writer’s favour, provided the underlying price and implied volatility don’t move sharply against them
• The writer can close the trade at will, removing any obligation placed

Risks of being an options writer

There are several risks associated with options writing, including implied volatility factors influenced by market volatility.

• They face substantial losses should the market move against them.
• Writers must maintain a margin account against significant losses.
• Stringent management strategies to minimise risk are imperative to maintain
• Tax implications generated by additional income from the premium income

Exploring naked options writing

Writing uncovered options, also called 'naked' options, holds the possibility for maximum loss — almost unlimited —because the writer does not hold any assets that they are obligated to deliver if the option is exercised. In other words, naked options have no downside protection.

A naked writer owns none of the underlying security. The naked call writer holds no long position. These naked options are also called 'uncovered' options.

In contrast, a covered call strategy involves the writer covering the call by owning the underlying security on which the call is written, typically in a low-volatility environment.

Naked call options

Naked writers aim at profiting from the upfront full premiums paid by buyers, without hedging against market conditions, price movements, or volatility of the underlying stock or security price. Therefore, the best-case scenario and most beneficial outcome for the naked writer is if the contract expires 'out of the money' or worthless.

Since there is no cap on how high a stock price rises or a security price can rise, unlimited loss becomes an additional risk, especially if the seller cannot manage to buy back their options before the price reaches a higher price, leading to a higher risk of loss.

Risk of naked options writing

Not holding the underlying stock or asset of an options contract exposes the writer to significant risk. Should the price of the underlying asset rise quickly, a call option seller with no coverage faces potentially unlimited losses.

Despite this risk, option writing remains popular due to the potential for substantial premium income. Traders and investors should thoroughly understand the mechanics, risks, and management strategies to employ before entering this market.  

The bottom line

To sum it up, the option writer is the market participant who creates and sells an options contract. To become a writer, one must be willing and able to take on the potential risk of trading options contracts.

Option writers need sufficient capital, an adequate understanding of the options market, including options type, the mechanics of writing options, and possess the character traits to accept the additional downside risk of possible unlimited loss that may be involved in options trading. 

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FAQs

What is an intraday option writing strategy?

Intraday options writing is a strategy where someone opens and closes a position across a single trading session to capture time decay and benefit from the option losing value quickly as the expiration draws nearer. Advantages include small but consistent premium income, a higher probability of profit over buying options, and reduced overnight risk since they are closed by the end of the trading day. Risks of intraday options writing include potentially unlimited losses, high margin requirements, susceptibility to sudden spikes in volatility, and the need for close attention to assignment risk and strict risk management, as a single significant move can wipe out multiple small gains.

How can you trade in option writing?

To become an options writer, one needs to understand the mechanics of writing contracts for sale. To trade in option writing, you need to understand the basic mechanics of writing an option, which involves creating a new contract that someone else can buy. This can be done with both calls and puts, and it can be a lucrative, albeit risky, endeavor.

How is options trading different from stock trading?

The trading strategy for stocks is simple: buy at a lower price, sell when the price of the stock rises. Stock traders purchase stock at a certain price with the anticipation that the value (and price) of the stock will increase, unless there is a bearish outlook. Stock prices are based on current market demand, so the higher the demand, the more expensive they will be. Conversely, the price goes down when demand drops. Options work differently. As derivatives, they are more complex than a simple one-for-one transaction. When the value underlying the asset of a call option increases, the option itself should increase in value. When the value of the underlying drops, the value of a put option should increase.

How do option writers make money?

An options writer sells options contracts to buyers for which they collect an upfront fee, or premium. This premium is the primary source of income for option writers, particularly when those options expire worthless or are closed for a profit.

Who purchases options?

Buyers of options include retail investors, institutional investors, hedge funds, broker-dealers, and market makers, depending on the market and product.

Who issues options?

In the United States, listed options are issued and guaranteed by the Options Clearing Corporation (OCC), which acts as central counterparty, becoming the buyer to every seller and the seller to every buyer.  The U.S. Commodity Futures Trading Commission (CFTC) and the U.S. Securities and Exchange Commission (SEC) regulate the OCC.

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This material is for informational purposes only and should not be considered as an investment recommendation or a personal recommendation.