Option writer

What Is an Option Writer?

An option writer, also known as an option seller, is an investor who creates and sells an option contract. This individual or entity takes on the obligation to fulfill the terms of the option if the buyer chooses to exercise it. Option writing is a fundamental concept within derivatives, a broader financial category, and involves receiving a premium upfront from the option buyer in exchange for taking on this obligation. An option writer can sell either a call option or a put option. The primary motivation for an option writer is typically to generate income from the collected premium.

History and Origin

The concept of options dates back to ancient times, with an early reference found in Aristotle's "Politics," describing Thales of Miletus's use of a similar concept to control olive presses. Modern options trading, however, gained significant traction with the establishment of standardized, exchange-traded options. This pivotal moment occurred in 1973 with the founding of the Chicago Board Options Exchange (CBOE). Prior to this, options were traded over-the-counter with unstandardized terms¹⁴, ¹⁵. The CBOE introduced standardized contract sizes, strike prices, and expiration dates, along with a centralized clearinghouse, the Options Clearing Corporation (OCC), which guaranteed the performance of contracts¹², ¹³. This standardization made options more accessible and liquid, paving the way for the sophisticated options market seen today.

Key Takeaways

• An option writer sells an option contract and receives a premium.
• The writer takes on an obligation to buy or sell the underlying asset if the option is exercised.
• Their maximum profit is generally limited to the premium received.
• Writing uncovered options carries significant, potentially unlimited, risk.
• Option writing strategies are employed to generate income or hedge existing positions.

Formula and Calculation

The premium received by an option writer is determined by various factors, often modeled using complex pricing models such as the Black-Scholes model. While the writer doesn't calculate the premium directly through a simple formula, understanding the inputs to such models helps in interpreting the premium. Key variables influencing an option's premium include:

• Underlying Asset Price ((S)): The current market price of the asset on which the option is based.
• Strike Price ((K)): The price at which the underlying asset can be bought or sold if the option is exercised.
• Time to Expiration ((T)): The remaining time until the option contract expires. Longer times generally lead to higher premiums due to more uncertainty.
• Volatility ((\sigma)): The degree of variation of the underlying asset's price over time. Higher volatility typically results in higher premiums.
• Risk-Free Interest Rate ((r)): The rate of return on a risk-free investment.

For a call option writer, the profit/loss at expiration is:

For a put option writer, the profit/loss at expiration is:

Where (S_T) is the price of the underlying asset at expiration.

Interpreting the Option Writer

An option writer's position can be interpreted in terms of their market outlook and risk exposure. When an investor writes a call option, they generally have a neutral to bearish outlook on the underlying asset, believing its price will either stay below the strike price or not rise significantly above it by expiration. Conversely, writing a put option indicates a neutral to bullish view, expecting the underlying asset's price to remain above the strike price or not fall substantially.

The premium received is the maximum profit for the option writer, representing the compensation for taking on the obligation. The interpretation of this premium is crucial; a higher premium often indicates greater perceived risk by the market, such as higher implied volatility. Understanding concepts like in-the-money and out-of-the-money options helps the option writer assess their potential obligations and the likelihood of the option being exercised against them.

Hypothetical Example

Consider an investor, Sarah, who believes that shares of TechCo (current price: $100) will not rise significantly in the next month. To generate income, she decides to act as an option writer and sell a call option with a strike price of $105 expiring in one month. For this, she receives a premium of $2 per share (or $200 for a standard 100-share contract).

• Scenario 1: TechCo's price at expiration is $102. The option expires worthless because the price is below the $105 strike. Sarah keeps the entire $200 premium, which is her maximum profit.
• Scenario 2: TechCo's price at expiration is $106. The option is in-the-money, and the buyer will likely exercise. Sarah is obligated to sell 100 shares of TechCo at $105. Since the market price is $106, she would effectively lose $1 per share ($106 - $105 = $1 loss on the obligation, before accounting for premium). Her net profit would be the $2 premium received minus the $1 loss per share, resulting in a net profit of $1 per share (or $100 total).
• Scenario 3: TechCo's price at expiration is $110. The option is exercised. Sarah sells 100 shares at $105. She effectively loses $5 per share ($110 - $105 = $5 loss on the obligation). Her net loss would be $5 per share minus the $2 premium received, resulting in a net loss of $3 per share (or $300 total). This illustrates the unlimited risk of writing uncovered calls.

Practical Applications

Option writing has several practical applications in finance and investing, particularly within the realm of portfolio management and risk management.

• Income Generation: The most straightforward application is earning premium income. Investors might repeatedly write covered calls against stock they own to generate regular income, especially in sideways markets.
• Hedging: Option writers can use their positions to hedge existing exposures. For instance, an investor holding a large stock position might write call options to gain some downside protection, knowing that if the stock price falls, the premium collected will partially offset the loss in the stock's value. Conversely, writing put options can be part of a strategy to acquire stock at a lower price while earning income.
• Volatility Plays: Option writers often capitalize on declining implied volatility. When market volatility is high, option premiums are inflated. An option writer might sell options, anticipating that volatility will decrease, leading to a reduction in the option's value and allowing them to buy it back at a lower price or let it expire worthless.
• Risk Mitigation (for covered options): When an option writer sells a covered call, meaning they own the underlying shares, their risk is limited. If the call is exercised, they simply sell their existing shares at the strike price. This contrasts with writing an uncovered call, which carries unlimited risk.
• Regulatory Framework: The options market is highly regulated to protect investors and maintain market integrity. In the U.S., the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) are the primary regulatory bodies overseeing options trading¹⁰, ¹¹. The SEC oversees options on stocks, while the CFTC regulates options on commodities and futures⁸, ⁹. These bodies impose rules on aspects such as position limits, margin requirements, and reporting standards to manage the inherent leverage and risks associated with options⁷.

Limitations and Criticisms

Despite the potential benefits, option writing carries significant limitations and criticisms, primarily centered on risk.

The most substantial risk for an option writer, especially with uncovered options (also known as naked options), is the potential for unlimited losses. For an uncovered call writer, there is no theoretical limit to how high the underlying asset's price can rise, exposing the writer to potentially catastrophic losses⁶. Similarly, an uncovered put writer faces substantial risk if the underlying asset's price falls significantly, though losses are theoretically limited to the strike price (minus the premium received) if the price drops to zero.

Another criticism is that the maximum profit for an option writer is limited to the premium received, regardless of how favorably the market moves. This contrasts with the potentially unlimited profit for a long option holder. This limited profit potential, coupled with potentially unlimited risk, means the risk/reward profile can be skewed against the option writer in certain strategies.

Moreover, option writing requires careful monitoring and often involves margin accounts, which can amplify both gains and losses. Early assignment risk is also a factor, particularly for American-style options, where the buyer can exercise the option at any time before expiration⁴, ⁵. This can force the option writer to fulfill their obligation unexpectedly, potentially at an unfavorable price. Academic research has also explored how option grants to corporate managers can influence their risk-taking behavior, suggesting that while options may encourage risk-taking, the net effect can be complex and sometimes controversial³.

Option Writer vs. Option Holder

The fundamental difference between an option writer and an option holder lies in their rights, obligations, and risk/reward profiles.

An option holder (or option buyer) pays a premium to acquire the right, but not the obligation, to buy or sell an underlying asset at a specified strike price before or on a specific expiration date. Their maximum loss is limited to the premium paid, while their potential profit can be theoretically unlimited for a call option or substantial for a put option if the market moves significantly in their favor.

Conversely, an option writer (or option seller) receives a premium for taking on the obligation to buy or sell the underlying asset if the option holder chooses to exercise their right. The option writer's maximum profit is limited to the premium received. However, their potential loss can be unlimited for an uncovered call and substantial for an uncovered put. The option writer typically profits when the option expires worthless or can be bought back for less than the premium originally received.

FAQs

What does it mean to "write" an option?

To "write" an option means to sell an option contract to another party. When you write an option, you create the contract and take on the obligation to buy or sell the underlying asset if the option is exercised by the buyer. In return for taking on this obligation, you receive a premium from the option buyer.

What is the primary goal of an option writer?

The primary goal of an option writer is typically to generate income from the premium received. They profit if the option expires worthless or if they can buy it back at a price lower than the premium they initially received. This strategy is often employed when an option writer believes the price of the underlying asset will remain stable, move favorably, or not move beyond a certain point.

What is the risk involved in writing options?

The risk involved in writing options varies significantly based on whether the option is "covered" or "uncovered." Writing a covered option means you own the underlying asset (for a call) or have cash/securities set aside (for a put) to meet the obligation, limiting your risk. However, writing an uncovered option carries substantial risk, potentially unlimited for uncovered calls, as there is no cap on how high the underlying asset's price can rise².

Do option writers want volatility?

Generally, option writers, particularly those selling options without an offsetting position (naked options), benefit from lower volatility. When volatility decreases, the value of options tends to decline, making it more likely for the written option to expire worthless or to be bought back at a lower price. However, some strategies, such as selling options during periods of unusually high implied volatility, aim to profit from an anticipated return to normal volatility levels.

How are option writers regulated?

In the United States, option writers and the options market as a whole are regulated by agencies such as the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC)¹. These regulators establish rules concerning position limits, margin requirements, and disclosure to protect investors and maintain orderly markets. Investors should also be aware of the specific rules and requirements set by their brokerage firms.