What Is an Option Writer?
An option writer, or seller, stands to profit initially from the premium payment received for granting the buyer the right to buy or sell an underlying asset. Writers can engage in selling both call and put options, and these can either be covered or uncovered. A position is termed ‘covered’ when the writer owns the underlying asset or holds an equivalent offsetting position; otherwise, it is considered ’naked’, exposing the writer to potentially very high losses. For example, if you own 100 shares of stock, you could sell a call option on them, collecting a premium from the buyer; your position is covered because you already possess the stocks and agree to sell them at the contract’s strike price. Selling put options could involve being short the shares while writing a put on them, still rendering the position covered. Without offset backing, the writer incurs significant risks as the stock’s chances of extreme price moves increase.
Key Takeaways
- Option writers gather a premium by giving buyers the right to purchase or sell the underlying security at a stipulated price within a specific period.
- Covered positions cushion risk, whereas uncovered positions heighten exposure to potential large losses.
- Option writers aim for premiums, ideally when options expire worthless and out-of-the-money, hence retaining the entire premium. In contrast, option buyers profit from in-the-money option expirations.
Empower Your Portfolio: Understanding the Option Writer’s Mindset
Option buyers acquire the right to engage in transactions with the underlying security’s stipulated price and time frame, paying a premium to the writer for this privilege. The writer gets compensated upfront but deals with heightened risk if the option escalates in value. For instance, a put writer anticipates the underlying stock retains its value above the strike price — their adversity begins when its price declines below the strike price, leading to considerable losses for the writer while proving lucrative for the buyer.
An uncovered writing occurs when neither an offsetting position nor own holdings support the option. For example, a put writer who commits to buying shares at a specific strike price stands the risk of falling into a predicament without a corresponding short position to compensate the potential losses tied with those shares.
Options written in an uncovered manner may conjure significant liabilities for their author, especially with price movements not in their favor. Conversely, covered writing surmounts the potential losses and is often viewed as a conservative income strategy compared to highly speculative naked writings.
Master the Art of Call Writing
Some traders employ a covered call strategy, notably for dividend-paying stocks. Covered call writing often transpires in three main outcomes: the options may expire worthless permit the writer to retain the entire premium; alternatively, in-the-money options prompt writers to either surrender their shares at the strike price (called away) or counteract and close the position by buying back the option.
Uncovered calls share the same fate save for the urgency to procure shares at the current market rate to meet the requirements of an in-the-money option owing to avoiding dire losses balancing out the current market price gap and initially received premium.
Becoming Proficient at Put Writing
If a put writer is devoid of effective shares against the sold put option, it becomes an uncovered action. A put position writing backed by corresponding short positions fortifying against a future in-the-money situation abates substantial losses, transiting successfully generating considerable returns.
Premium Time Value: The Option Writer’s Lifeblood
Time value drastically impacts the premium for which options trade. Longer expiration translates to a higher probability of moving into-the-money availing more value recognition to buyers due to heightened uncertainty. Options degrade in time value nearing speedy expiry timelines benefiting the privileged state of option writers gathering full retainable premium as out-of-the-money options naturally vest as worthless.
The centerpiece premise valiantly replete authentic and diversified options signifies a prosperous venture paved or fortified through an exhaustive features’ assimilation captivating breaches conversely mitigated somehow tactical recognized benefits associated assert advantageously seemingly required.
Masterclass Example: Writing a Profitable Call Option on a Leading Stock Like Apple
Consider a situation where Apple Inc. (AAPL) shares trade at $210. The trader anticipates the shares won’t surpass $220 in the next two months and hence writes a call option at a $220 strike price for $3.50 each. Accordingly, they attain $350 ($3.50 × 100 shares), retaining that as long as Apple’s price remains lower than $220 up to the expiry. Suppose the writer already owns shares at $210 marking a cover call incision, and prides security against excessive asset inclines in reflecting extensive risks exponentially distributed otherwise.
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Related Terms: grantor, premium, naked option, call option, strike price, put option, short position, buyout, exercise, share price, intrinsic value, time value.
