What is Option Writer?

Options trading is an advanced financial strategy that has gained popularity among investors and traders seeking to diversify their portfolios. Within this domain, the role of an option writer is pivotal. Option writers are individuals or entities who sell options contracts to buyers, earning premiums in exchange for taking on specific obligations. This article delves into the meaning, benefits, and risks associated with option writing, providing a comprehensive guide for those curious about this trading strategy.

Investing in options requires a thorough understanding of market dynamics, and option writing, in particular, carries unique opportunities and challenges. Let us explore what option writing entails and how it can be strategically employed in the stock market.

Option writing, also known as selling options, is a trading strategy where an individual or entity (the option writer) sells an options contract to a buyer. In this process, the writer earns a premium — a fee paid by the buyer for the right to buy or sell the underlying asset at a predetermined price within a specific timeframe.

Key aspects of option writing:

1. Obligations of the writer: Unlike option buyers, who have the right but not the obligation to execute the contract, the option writer is obligated to fulfil the contract terms if the buyer exercises the option.
2. Types of options: Option writing can involve either:
   • Call options: The writer agrees to sell the underlying asset at the strike price if the buyer exercises the option.
   • Put options: The writer agrees to buy the underlying asset at the strike price if the buyer exercises the option.
3. Market scenarios: Option writing is typically employed in sideways or bearish markets, where the likelihood of the option being exercised is lower, allowing the writer to retain the premium as profit.

Option writing is considered a high-risk strategy, particularly for those with uncovered or “naked” positions, as potential losses can be significant if the market moves unfavourably.

An option writer is a trader or investor who sells options contracts to buyers in exchange for a premium. The writer’s role involves taking on the obligation to either sell (in the case of call options) or buy (in the case of put options) the underlying asset if the buyer exercises the contract.

Option writers are required to maintain margin deposits as mandated by SEBI to mitigate the risks associated with their positions. Their profit primarily comes from the premium earned, which they retain if the option expires worthless. However, they must carefully evaluate market trends and their risk appetite before engaging in this strategy.

Call writing is a popular strategy among traders and investors, particularly in neutral or bearish market conditions. The primary objectives and benefits of call writing include:

• Earning premiums: The premium received from selling call options provides a steady income stream for the writer.
• Risk management: Call writing can be used as a hedging strategy to offset potential losses in an existing portfolio.
• Market-neutral strategy: In a sideways market, call writing allows traders to profit from minimal price movement in the underlying asset.

While call writing offers these benefits, it is essential to balance potential rewards with the associated risks.

Option writing is inherently risky, and traders must understand the potential downsides before employing this strategy. Here are some of the key risks associated with option writing:

1. Unlimited loss potential

• Call options: If the price of the underlying asset rises significantly, the call writer may face unlimited losses as they are obligated to sell the asset at the strike price, regardless of its market value.
• Put options: If the price of the underlying asset falls sharply, the put writer may incur substantial losses as they are required to purchase the asset at the strike price.

2. Market volatility

Unpredictable market movements can lead to significant losses for option writers. Volatility increases the likelihood of the option being exercised, which may result in financial losses.

3. Margin requirements

Option writers are required to maintain margin deposits as per SEBI regulations. If the market moves unfavourably, they may need to deposit additional funds to maintain their positions, adding to the financial burden.

4. Time decay risk

While option writers benefit from time decay (as the option’s value decreases closer to expiration), unexpected market events can still lead to losses, even in the final stages of the contract.

5. Specific risks for call and put writers

• Call writers: Face the risk of sharp price increases in the underlying asset, leading to potentially unlimited losses.
• Put writers: Are exposed to steep price drops, which can result in significant financial obligations.

Risk management tips for option writers:

• Understand market trends: Conduct thorough research and analysis before entering a trade.
• Set realistic expectations: Avoid speculative trading and focus on strategies that align with your risk tolerance.
• Use covered positions: Writing covered calls or puts can help mitigate risks by ensuring you own the underlying asset.
• Adhere to margin requirements: Maintain sufficient funds to meet margin calls and avoid forced liquidation of positions.

To understand the mechanics of call option writing, let us consider a hypothetical example:

1. Setting up the trade:
   • Underlying stock: ABC Ltd.
   • Strike price: Rs. 1,000
   • Premium: Rs. 50 per share
   • Lot size: 100 shares
2. Premium earnings:
   • The writer sells one call option contract for a total premium of Rs. 5,000 (Rs. 50 x 100 shares).
3. Profit/loss scenarios:
   • Scenario 1 – Profitable: If ABC Ltd.’s stock price remains below Rs. 1,000 at expiration, the option expires worthless, and the writer retains the Rs. 5,000 premium as profit.
   • Scenario 2 – Loss-making: If ABC Ltd.’s stock price rises to Rs. 1,200, the writer incurs a loss of Rs. 15,000 [(Rs. 200 x 100 shares) - Rs. 5,000 premium].

This example highlights the importance of carefully assessing market conditions and potential risks before writing call options.

Option writing is a sophisticated trading strategy that offers the potential for earning premiums and managing risk in specific market conditions. However, it is not without its challenges. The risks associated with unlimited losses, market volatility, and margin requirements make it crucial for traders to approach option writing with caution and proper risk management strategies. Before engaging in option writing, investors should evaluate their financial goals, risk tolerance, and market knowledge. As with any investment, it is essential to remember that past performance is not indicative of future returns.

Investments in securities markets are subject to market risks. Please read all scheme-related documents carefully before investing. Bajaj Broking does not provide investment advisory services.