What are the options?
Investopedia defines options as ‘The term option refers to a financial instrument that is based on the value of underlying securities such as stocks. An options contract offers the buyer the opportunity to buy or sell—depending on the type of contract they hold—the underlying asset’
They differ from futures in the sense that they give the holder an option to carry forward with the deal – they are not obligated to do so. There is however a specific expiration date by which the holder must exercise their options.
There are two kinds of options – call and put options. Though there is a huge upside in terms of potential for profit, there is also an equal risk so traders must tread carefully.
What do we mean by writing options?
Now there are two players in an option transaction – a buyer and seller. Most people prefer to buy options (because of limited downside) and thus that is the more common practice. To sell options is often termed as writing options (since the process involves one first creating an option and then selling it).
How does the risk-reward play out?
The upside for a trader is the amount of premium he receives. In return, they have to give the buyer the option to buy/sell etc. The amount of this premium depends on numerous factors like the prevailing price of the stock, time frame to expiry, volatility of the underlying stock, etc. Note here that the party writing the option will receive this premium under any circumstance – the buyer may choose to not invoke the option (the option expires out of the money) but has to pay the premium nonetheless. The upside here is therefore guaranteed, but it is also limited. It is impossible for the option writer to make more money than the amount of premium.
Another upside here is that the premium to the seller is received immediately unlike that of the buyer who receives their upside (if any) at a later date.
Another advantage is the time decay factor. Options decline in value as time passes, and that reduces the option writer’s risk and liability. As its value has dropped, the option writer can sometimes buy the option back at a lower price. (They have already sold it at a higher price and received a premium against it)
Now let us discuss the risks involved. Unlike the upside which is limited, the downside is unlimited. Let us take an example of a call option to understand this. A buyer will exert his option if the trading price exceeds the strike price. The difference is essentially the seller’s loss. This loss is therefore unlimited as the trading price can rise by any amount- there is no cap on it.
A potential way for option writers to hedge themselves is to take related positions. Suppose an option writer has sold a call option. They are betting on the price to remain flat or decline. But the price increases leading to a loss for the option writer. A good related position for such a trade that the option writer can take is that they can also go long on the stock. The proceeds received from booking profits in this long position can be used to offset the losses incurred in the options trade.
Another small disadvantage here is that options writing usually requires more margin than buying options as the downside is limited. Plus the trader is exposed to price volatility which works against their favor (unlike in buying an option)
More details
Call and put options are usually in lots with a size of 100 shares. The process of writing options is not that complicated that it will deter beginners from giving it a shot. At the same time, it is prudent to be aware of the technicalities of such activities. An option writing course is a good starting point for all looking to venture into this space.
Options writing course will add a lot of structure and discipline to one’s learning pace. At the same time, one gets to exploit the opportunities to meet extremely distinguished and experienced traders in the industry who have been in the market for years. Such an experience will truly be unparalleled. A word of advice – try and find courses offered by institutions that also come with a community. There is nothing better than learning from your peers and helping each other become better professionals in the field.
In conclusion, options writing is a very interesting and very lucrative path to go down on. However, it is always better to be safe than sorry. It is strongly recommended that one opt for a holistic course on options writing. Also, do not forget that practice makes one perfect so don’t forget to follow the equity and derivatives market too.
