"OPTIONS WRITING: ADVANTAGE & DISADVANTAGE"

PTIONS WRITING: ADVANTAGE & DISADVANTAGE"

INTRODUCTION:

Option writing is a term used to describe any option trading strategy that involves selling options. This is the act of creating and selling new options contracts in the public exchange. In layman terms, options writing is options trading term for "shorting" options. Options writers are simply the people who short options. Since the invention of options trading, options writing has been worshiped as being the "pro" way of trading options and a way to play "bookmaker". So what exactly is options writing, what happens when you write an option and how is options writing profitable? 
WHAT EXACTLY OPTIONS WRITING:

Well, if writing options is simply "shorting" options, why call it options writing and not simply "shorting" like in stock trading? Even though the effects of writing an option is the same as shorting a security such as a stock, the internal process and logic is actually quite different, which justifies the different terms used.

The term "writing" actually comes from the insurance industry where insurers underwrite policies. Indeed, options are a form of "insurance" for stocks when used for hedging purpose. When you write an insurance policy, a new policy is created just for you which did not exist before. That is also what happens when you write an option. When you write an options contract, you are playing "insurer" and creating brand new an options contract that did not exist in the marketplace before. It is exactly like you writing up a new contract for sale to the holder, hence the term "writing an option". When one contract of an option is written in options trading, the open interest for that options contract increases by one, informing all options traders that there are now one more active options contract in the market.

In contrast, when you short a stock, you are not creating a new share of stock in the marketplace but rather borrowing shares from the broker and selling it when you don't own it. Hence it is a short sale. As you can see, the process of shorting is totally different from the process of writing an option, which is why the terms are different.

HOW DO YOU WRITE OPTIONS?

Anyone with an options trading account can write options in the market as long as you have enough cash to cover margin requirements. Margin is cash you need to have in your account before you are allowed to write options or perform credit spreads. It is like having the capital to start selling options as a business.

You can write options simply by using the Sell to open order. Your broker would do all the internal processes of creating a new options contract and selling it in the marketplace. The process is really invisible to the trader and the effect is exactly like shorting a stock.

For example:  XYZ company shares are trading at Rs. 50 right now. Rs. 50 strike price Call Options are trading at Rs. 2.00.  In order to write its Rs.50 you need to Sell To Open those Rs.50 strike price call options and receive Rs. 200  (Rs. 50 X 2) in your account for each contract written.

Conversely, in order to close out options positions that you wrote, you need to use the Buy To Open order.

On the above example, XYZ company shares are trading at Rs. 50 right now. Rs. 50 strike price Call Options are trading at Rs. 2.00.  In order to close the Rs. 50 call options position that you wrote, you need to Buy To Close those Rs. 50 strike price call options. Doing so buys back that options contract you wrote and closes the trade.

There are so many procedures for call and/or put writing. Some of them are Covered call writing, Naked call writing, Naked put writing, Bear call Spreads and Bull put Spreads.  One may find out the details on Wikipedia.
When you write call options without owning the underlying stock, your position is not covered and hence a "Naked Write". This means that you are writing a call option, giving someone the right to buy the stock from you when you do not have the stock in the first place. This is why margin is required for naked writes. Margin makes sure that when the call options are exercised, you have the cash to buy the stock from the market in order to deliver to the person who bought your call options. When you own the underlying stock, the call options you wrote would be considered a "Covered Write" as in the Covered call options trading strategy.

WHY WRITE OPTIONS (ADVANTAGE):

When you write an option, the buyer of your options contract pays you an amount of money for the risk that you are undertaking. This is known as the options premium. Upon expiration of the options contract, if the option is not exercised, you get to keep that premium as profit.

Following up on the example above, you get to keep the Rs. 200 of options premium if XYZ stock closes at or below the strike price of Rs. 50.

Yes, this means that by writing call options instead of shorting the stock itself, you not only profit when the stock goes down but also when the stock does not move at all! Doesn't that sound like playing bookmaker? That is why options writing is playing bookmaker to traders who wants to do a directional bet.

Another advantage of options writing is that it puts Time Decay in your favour. Time Decay is the number one enemy of options buyers. It is the phenomena where options become cheaper as expiration date draws nearer. When options become cheaper over time, it becomes more profitable for the options writer to buy back those options they wrote in order to close the position.

Following up on the example above, 10 days after you write those call options, XYZ stock remained stagnant and its Rs. 50 strike price call options is now asking at Rs. 1.10. You can now buy to close the call options you wrote at Rs. 1.10, making a profit of Rs. 0.90 (since you sold it for Rs. 2.00).

DISADVANTAGE OF OPTIONS WRITING:

The clear disadvantage of options writing is the fact that you are liable to the fulfillment of the terms of the options that you wrote. If you wrote a call option, you are liable to selling the stock at the strike price no matter what the prevailing market price of the stock is.

Following up on the example above, assuming XYZ stock rises to Rs. 80 upon expiration of the Rs. 50 strike price call options. The call options you wrote gets assigned and you need to buy the stock at the market price of Rs. 80 and sell it to the holder of your call options at the strike price of Rs. 50, incurring a loss of Rs. 30 per share.

As you might have noticed by now, writing options subject you to unlimited loss liability,  putting you deeper into loss as long as the underlying stock move against your favour. As such, even though options writing has the ability to profit from 2 of the 3 possible directions, the unfavourable direction would subject you to unlimited liability.
Options writing also requires significant margin, which means that you need a lot of cash in your account before you are allowed to write a single options contract. In some cases, you need as much as Rs. 100,000 in your account before you allowed to write a single options contract. This high margin requirement usually stop options writing from being a strategy for options trading beginners or traders with very small accounts. one may find out from their Broker as to what actual margin money is required since the Broker charges different margin money (a little bit) to their client. However, in a covered call writing (when you usually own the same number i.e., lot size of stocks in cash segments), no margin money is required but in that case those stocks will be freeze for your selling in Cash Segment till expiry or you cover your written call whichever is earlier.

In a nutshell, the primary objective in writing options is to earn the premium paid by the option buyer. An option writer sells options intending to profit from the decline of extrinsic value on options, referred to as time value. If the option expires without being exercised, the writer keeps the full amount of the premium. If the option buyer exercises the option, however, the writer must pay the difference between the market value and the exercise price.

Note: One must be fully aware about the strategies for call writing, otherwise, it may causes a heavy loss. It is understood that those who wishes to learn about Call Writing, they surely know about option trading and its effect.