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Options Writing / Options Writer: Summary
Options Writing - Definition
Options Writing is the act of creating and selling new options contracts in the public exchange.
Options Writing - Introduction
In layman terms, options writing is options trading term for "shorting" options. Options writers are simply then people who short options. Since the invention of options trading, options writing has been worshipped 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?
This tutorial shall explore these issues and more in layman terms and examples.
What Exactly is 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. Its 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 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 US 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. Its like having the capital to start selling options as a business.
You can write options simply by using the Sell To Open order. Your options trading 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.
Conversely, in order to close out options positions that you wrote, you need to use the Buy To Close order.
For the considerations and more details on how to write call and put options profitably, please refer to the full tutorial on Naked Call Write and Naked Put Write.
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?
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.
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 favor. 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.
Disadvantages 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.
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 favor. As such, even though options writing has the ability to profit from 2 of the 3 possible directions, the disfavorable 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 $100,000USD in your account before you are 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.
Options Writing Questions
:: Is Writing Put Options Speculating or Hedging?