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Options Writing / Writing an Option

What does options writing mean? How does one go about writing an option? What are the advantages and disadvantages of writing options?

Options Writing - Definition

Options Writing is the act of creating and selling new options contracts in the public exchange.

Options Writing - Introduction

How do you write options and be the "Banker"?

What happens when you write options?

In layman terms, options writing is options trading term for "shorting" options. Many options beginners also like to use the term "selling" options but that can be easily confused with selling an option that you own to close the position. As such, the terms "shorting" or "writing" should be used instead to avoid confusing this with closing of a long options position. Options writers are simply people who short options. Yes, one of way understanding what "writing options" is, is that it is similar in concept to shorting a stock. 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.

How is Writing Options Different From Shorting Stocks?

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 options 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.

What Does It Mean To Write An Option?

When you write an option, you are creating a new options contract and then selling it publicly to an options trader who is looking to buy that options contract. As such you are playing the "banker" in that options transaction and will be responsible for the fulfillment of that options contract should the buyer of that options contract decide to exercise the option.

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. However, margin will not be required when writing an option if you have the underlying asset in your account which could be used for delivery in the event of an exercise or that you have enough of similar long options that can give you enough of the underlying asset in order to cover a delivery as in the case of using debit spreads.

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.

Options Writing Example

XYZ company shares are trading at $50 right now. $50 strike price Call Options are trading at $2.00.

In order to write its $50 call options, you need to Sell To Open those $50 strike price call options and receive $200 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 Close order.

Options Writing Example

XYZ company shares are trading at $50 right now. $50 strike price Call Options are trading at $2.00.

In order to close the $50 call options position that you wrote, you need to Buy To Close those $50 strike price call options. Doing so buys back that options contract you wrote and closes the trade.

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 or our free tutorial on Selling Put Options with infographic and video.

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.

This is why some people refer to the Covered Call strategy as the Covered Write 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.

Options Writing Example

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

Options Writing Example

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

Writing a call option
Options Writer (left) Selling An Option

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.

Options Writing Example

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

Another little known disadvantage of writing call options is that if the underlying stock of the call options you wrote is paying dividends, you will be liable for paying the dividend should the call options are exercised and you end up with short stocks. This is how alot of options traders trading options spreads like the Iron Condor Spread get themselves trapped in a huge seemingly risk free position ahead of dividend paying day and then get hit with a loss of tens of thousands.

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?

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