Writing Options

In order to buy an option contract on something, either a call option in anticipation of the price of an asset rising, or a put option that accrues value if the price goes down enough, you need to buy these options from someone.

Normally, with securities, you purchase the security from someone else if you are going long, anticipating a prince increase, or borrow the security from someone and sell it, with the goal of buying it back later at a lower price and paying back the borrowed security at a profit.

Writing OptionsWhat makes options different is that the security itself isn’t traded, but rather an option, an opportunity to receive a security at a certain price in the future. Futures work this way as well but futures contracts get entered into by parties originally and you are taking the stake of one party or another when you purchase them in the market, in other words you are buying the contracts from others.

When you buy options, you are also often buying them from other traders, but the contract would have to be written by the seller of it at some point. With a futures contract, the original participants in the contract can just sell their positions be out of them as they wish, but with options, someone has to cover the contract, as it’s just the people on the other side of the deal that trade.

For example, if you write a futures contract, it may change hands many times over the life of the contract, but if it finishes in the money, someone will be owed the shares or units or whatever is being optioned and you are going to have to come good for it.

Even though this does not mean that the options writer cannot absolve themselves of some of the risk by purchasing a counter option from someone else, you can see how options writing is different from other forms of trading, and when you write options, otherwise known as selling them, you are actually making the market here, which does come with its responsibilities.

Selling options does come with its rewards as well as its risks, but unless you cover yourself somehow, you are on the hook for the full amount of the contract at the price specified.

The Added Exposure of Options Writing

It is well known that people can make a lot of money from an options trade if they hold an option whose price really takes off in the direction of their trade. Movements in prices with options become significantly magnified, where one can earn many times what was paid for the option if it hits well enough.

Given that about 9 in 10 options expire out of the money, meaning only 1 in 10 finishes in the money, we know just from this that when an option strikes, it has to make 10 times more than it cost on average.

If this were not the case, it would not make sense to buy options, as they would have a negative expectation. So, the 10 times on average is the equilibrium point.

Returns on options that strike vary a lot though, from just a little profit with the ones that barely get past the strike price, to ones that go way over it. Therefore, options writers are exposed to much more risk than just losing 10 times what they collected from the premium, and they need to account for this risk somehow.

The theoretical risk limit with selling puts is the entire value of the underlying asset, and although things don’t lose their entire value or even half of it during the life of an options contract, they can go down quite a bit, especially if a market crash is involved.

Selling calls does not have a theoretical level of potential loss, as things can go up to any level, although there’s only so much something can be expected to rise during the limited life of an options contract, which usually only lasts a month.

This additional risk is captured by pricing in volatility into the premium for options, and option contracts with more volatility will tend to cost more than those whose assets are less volatile, to compensate for this additional risk.

Writing Covered Options Contracts

Options writers can hedge their positions by covering them with holdings of the underlying asset. Writing covered calls is the most popular form of option writing that is marketed to individual traders and investors, due to its relatively low risk of losses in dollars and cents compared to other option writing strategies.

With writing a covered call, one would already own the security that is being optioned. One may own 100 shares or some amount of a certain stock for instance, and sell a call option on it.

If the stock does not rise past the strike price, the options writer keeps the premium, as option writers always do, and this yields a profit on the option side of the deal. If the option finishes in the money, the option writer would simply sell their shares to the option buyer for the strike price.

If the price of the stock goes down, their position in the stock would lose value, as it would if they did nothing, and they would have the premium to buffer this loss.

So this seems like a fabulous deal looking at it this way, and some may wonder how this doesn’t always benefit the option seller. There is always a downside with trading though, and in this case it is having to give up the profits they would have made with their stock beyond the strike price if they had not sold the option.

Writing covered puts is more risky, as even though the option writer does take a position in the underlying asset, it is a short position. The idea here is that if the option turns against them, their losses are covered by the profits from the short sale, and they get the benefit of the premium.

The difference between covered calls and covered puts is what happens when the price makes a big move in the opposite direction of the option, going down with covered calls and up with covered puts.

You lose money both ways, but with selling calls, your stock loses value, and with covered puts, you need to come up with cash to cover any losses with the short. You can always cover whatever losses your stocks go down, if you own the stocks, but you may not be able to cover the losses from the short sale as this must come from money in your account, and it might move so much that you get a margin call and can lose a lot of money.

Uncovered or Naked Options Writing

Uncovered options writing, which is called naked options, involves situations where options are written without the seller having either a long or short position in the underlying asset. All of the losses that the option contract involves will then need to be settled in cash from one’s trading account.

Naked options can be riskier than covered options, but the difference tends to be exaggerated. What people don’t tend to take into account properly when comparing the two is the risk involved when the price of the underlying security moves opposite to the strike price, and even with covered calls, the large amount that one can lose on the stock is still money lost and still risk.

With covered puts, they aren’t a whole lot different than naked puts other than the risk being on the other side of the asset. So it might go down and you may lose a lot of money to the option buyer, or it might go up a lot and you may lose a lot of money to the market.

There still are some things you can do in order to manage this risk in your short positions, you can reduce them for instance or buy options to cover some of your risk, and with naked positions, you can always limit your risk by taking options positions at different strike prices, where your risk is defined by the difference in the strike price sold and the one bought.

For instance, if you sold a naked call at $55 and the price is at $50, and you wanted to reduce your risk to $10 a share, you could buy a call at $65, which would be quite a bit cheaper premium wise than what you received, due to the price difference.

Given that one can protect their naked positions easily, the only truly naked option is one that is not protected, that is indeed pretty risky.

The Reason Why Options are Sold

Option buyers are either bullish or bearish on a security, and if they are bullish they will buy a call, and if bearish, they will buy a put. So these bets are made, and on the other side of options bets are bets that the security will not go up enough or go down enough to pay off, or if it does pay off, the amount will be small enough to yield an overall profit with this type of scenario overall.

Determining such things is not such a simple matter though, and this is not a field for the less experienced or skilled. Even covered calls should be approached with considerable thought.

Sometimes it is not though, and perhaps an investor is going to be holding a position come what may, and therefore they may see selling covered calls as a low risk opportunity. Many investment writers try to portray them as such, although it’s not that much fun to watch securities you hold make money for someone else instead of for you when they run up.

This involves a loss, even though it might have not involved a cash loss, it’s still a loss of value which dollar for dollar cashes out to the same thing. This is not the sort of thing that buy and hold investors need to be thinking about much, especially since their trading skills are usually lacking, and this doesn’t usually bode well in the options market in particular, where the competition is particularly skilled.

For those who are up to it though, both skill wise and account wise, selling options can be a good way to speculate, although in this case the speculation is on something not happening rather than the usual expectation of a certain price move.

The risk with options writing can also be pretty well managed if you know what you are doing, although that part is extremely important. If so, and if you have a good working strategy, there is certainly real money that can be made from selling options.

Eric Baker

Editor, MarketReview.com

Eric has a deep understanding of what moves prices and how we can predict them to take advantage. He also understands why so many traders fail and how they may help themselves.

Contact Eric: [email protected]

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