An option is a contract that is based on the underlying security value. The buyer has the right but is not obliged to buy/sell an asset underlying at a set price on or before a particular date. An understanding of what an option is and what terms like call and put options help anyone interested in knowing about an option writer.
There are two types of options, call and put. A contract where the buyer has the right to buy an underlying asset at a pre-set price within the date of expiration is a call option. These assets that are underlying could be bonds, stocks or other securities. A put option gives the seller the right to sell the asset underlying at a pre-set price on a specific date. Both these contracts are not obligations on the part of the buyer or seller.
It also helps to understand what the term strike price means. The price at which a put/call option is or can be exercised is the strike price.
So, who is option writer and what is the role of option writer in stock market?
An option writer, also known as a granter or seller, is someone who sells an option and collects a premium from the buyer, by opening a position. The answer to who is option writer is that it is someone who creates a new options contract and sells it to a trader seeking to buy that contract. The underlying security sold could be either a covered or an uncovered or naked option. If the writer owns the security underlying then it becomes a covered option. If a writer does not own the underlying then it is a naked or uncovered option.
What is the difference between an option buyer and an option writer?
- A buyer of an option pays a premium and buys the option but is not under an obligation to exercise the option. The risks involved are limited to the premium that is paid while there are no limits on the rewards earned, on paper. As long as the stock market moves higher, the option buyer can stand to gain. On the flip side, there is the disadvantage of erosion of time.
- On the other hand, an option writer sells the option without holding long positions, much like short selling a stock. There is a high risk while the reward is limited to the extent of the premium that is received.
- A put option writer opens a position by selling put option and gets a premium. The reward here is only to the extent of the premium while the risks can be high if the price of the stock underlying drops lower than the strike price.
- Writing a call option involves the writer selling it to the buyer who has the right to buy it at a set price.
What are the advantages of being an option writer?
Now that you know who is option writer, you should consider the benefits that come with writing options. They are:
- The payment of premium which is paid upfront and is the potential reward.
- The retaining of the whole premium if the option expires out and no one wishes to exercise the contract.
- Time decay and the consequent reduction in value of the option means your risk and liability as a seller/write of options drops.
- You get to close the trade whenever you wish to by removing the obligation placed. You would need to buy back the option and close the trade.
What are the risks involved?
Option writers are exposed to price movements against them. This risk applies in the case of being an option writer in stock market as well. One way to overcome negative price movement is to include stop losses while writing options. A stop loss is an order that has been placed with a broker to either sell or buy a security upon touching a specific price.
Another risk is the initial margin risk which is higher. You would also have to face the risk of MTM or mark-to-market margins. An option seller would need to consider these margins when selling options.
It is important to consider both the advantages and disadvantages involved in option writing before turning a seller. Writing an option works well in scenarios where the stock market shows a trend very clearly.
An option writer is someone who sells an option and collects a premium from the buyer, by opening a position. The rewards are too restricted to the level of premium received on selling the option while the risks have no such limits. Therefore, it is important to understand the pros and cons of writing options. It also helps to have a thorough understanding of how options and the stock markets work before turning into a seller.