What Is Writing an Option?

Writing an option refers to selling an options contract in which a fee, or premium, is collected by the writer in exchange for the right to buy or sell shares at a future price and date. A naked option is another name for an exposed position. A writer who owns the stock that is the basis of the choice and has committed to sell those shares at the contract’s strike price is in a covered position. For instance, the owner of 100 shares of stock may sell a call option on those shares to earn a premium from the option buyer. Writing a put option on shares that you are short would be known as a covered put option. The option writer may suffer enormous losses if the underlying moves are against them and their option is not covered.

Understanding Writing an Option

The option seller or writer grants option purchasers the right to purchase or sell an underlying security at a predetermined price during a specific time window. The option has a price, known as the premium, for this privilege. What option writers are after is premium. They get payment up front, but if the chance turns out to be very valuable to the buyer, they run a significant risk of being exposed. For instance, while the buyer hopes the underlying stock will go below the strike price, the put writer hopes it won’t. The put buyer will benefit more from the put, while the writer will lose more the lower the underlying falls below the put’s strike price.

An alternative becomes available when the writer has no counterbalanced position in the account. For instance, if there isn’t a comparable short position in their performance to balance the risk of purchasing shares, the writer of a put option, who commits to buy shares at the contract’s strike price, is exposed.

If the options the writer writes about are discovered, they might result in significant losses. This indicates that they are not short shares in the options on which they write puts, nor do they own the shares on which they write calls. An unfavorable change in the underlying price may cause significant losses. For instance, in a call, the writer consents to sell the buyer shares at the strike price, which in this case would be $50. However, a different business offers to buy out the stock, selling it at $45 for $70 a share. The underlying price jumps to $65 and stays there for a while. It doesn’t get to $70 since there’s a possibility the transaction won’t close. If the buyer exercises the option, the option writer will now need to purchase shares for $65 to sell them to the buyer for $50. The option writer will still suffer a significant loss even if the option hasn’t expired since. They must purchase the option back for around $15 more ($65–$50) than they initially wrote it for to close out the position.

Option writers want to collect premiums to make money when contracts are sold to open a position. The most considerable profits are realized when sold contracts expire out-of-money. Call writers ‘ options expire out-of-the-money when the share price closes below the contract’s strike price. When the closing price of the underlying shares is higher than the strike price, out-of-money puts expire. The writer retains the total premium that was paid for the sale of the contracts in both scenarios.

The author may suffer a loss if the option goes into the money, as they will have to pay more to repurchase it than they were given.

Covered writing is seen as a cautious approach to revenue generation. It is hazardous because writing naked or exposed options has the potential for infinite losses.

Write Calls

One of three things usually happens when someone writes a cover call. The writer retains the premium they were paid to write the option until it expires. The writer has two alternatives if the choices expire in the money: either purchase the option to settle the position or let the underlying shares be called away at the strike price.

When they are called away, it indicates that the buyer of the option will acquire the shares from them once they sell the buyer their actual shares at the strike price. On the other hand, purchasing the identical choice to balance the previously sold option is known as closing the option position. The difference between the premium received and the cost to repurchase the option determines the profit or loss on this position closure.

With one significant exception, the results of writing uncovered calls are essentially the same. The writer must either liquidate the position or purchase stock on the open market to deliver shares to the option buyer if the share price closes in the money. The difference (a negative figure) between the strike price and the underlying open market price plus the originally paid premium is the loss.

Start Writing

If a matching number of shares are sold short in the account, the put writer’s temporary position in the underlying stock is covered. The temporary position balances the written put’s loss if the fast option closes in the money.

To close an uncovered position, the writer has two options: purchase shares at the strike price or purchase the identical option. The difference between the strike and open market prices, less the premium paid, is the writer’s loss if they buy the shares. The loss is the difference between the premiums paid to acquire and earned if the writer closes the position by buying a put option to balance the sold option.

Superior Time Worth

Writers of options focus particularly on time value. An option’s time value increases with the time left to expire since it is more likely to move into the money. Option purchasers will pay more for a comparable option with a more prolonged expiration than one with a shorter expiration because they appreciate this potential.

Time value diminishes with time, benefiting the option writer. The time value may be derived from an out-of-the-money option that trades for $5 without intrinsic worth. An option writer gets $5 if they sell this option. The option’s value will decline with time and expire worthless if it remains out of the money. Because the writer has already received $5 and the option is now worth $0, it is useless after it expires out of the money. Therefore, the writer can retain the premium.

The underlying strike price is the primary factor determining an option’s value as it approaches expiration. The option value will show the difference between the two prices if the option is in-the-money. The option seller still earns money even if the option expires in cash, and there is only a $3 difference between the striking price and the underlying price. This is because they earned $5 and can buy back the position for $3, which is expected to be the price at which the option will trade as it expires.

An Illustration of Writing a Stock Call Option

Let’s say that the price of Apple Inc.’s (AAPL) shares is $210. A trader writes a $220 strike price call option for $3.50 because they don’t think the shares will increase over $220 in the next two months. Accordingly, they get $350 ($3.50 x 100 shares). As long as Apple’s pricing is less than $220 when the option expires in two months, they can retain the $350.

The author may purchase 100 Apple shares at $210 to establish a covered call, or they may already possess shares. This safeguards them if the stock rises, let’s say, to $230. The writer would lose $650 (($10 – $3.50) x 100 shares) if they sold the option uncovered and the price increased to $230. In such a scenario, the writer would have to purchase shares at $230 to sell to the option buyer at $220. If they already had the shares, they could have sold them to the buyer for $220, earned $1,000 from the purchase of the shares ($10 x 100 shares), and kept the $350 from the option sale.

The drawback of the covered call is that, while they retain the $350 option premium if the share price declines, they will now hold shares whose value is declining. The writer keeps the $3.50 per share from the option but loses $20 per share ($2,000) on the shares they bought at $210. Suppose the shares drop below $190. It’s still preferable to lose $16.50 ($20–$3.50) per share than the $20 they would have lost if they had purchased the shares without selling the option.

Conclusion

• Option writers are paid a premium in return for granting the buyer the right to purchase or sell the underlying at a specific price within a predetermined time window.
• It can be covered or uncovered in a put or call since disclosed positions entail much more risk.
• Option writers desire that their options expire worthless and out-of-the-money to preserve the whole premium. Buyers of options want their contracts to pass in the money.