What Is an Option Writer?
A writer (sometimes referred to as a grantor) is the seller of an option who opens a position to collect a premium payment from the buyer. Writers can sell call or put options that are covered or uncovered. An uncovered position is also referred to as a naked option. For example, the owner of 100 shares of stock can sell a call option on those shares to collect a premium from the buyer of the option; the position is covered because the writer owns the stock that underlies the option and has agreed to sell those shares at the strike price of the contract. A covered put option would involve being short the shares and writing a put on them. If an option is not covered the option writer theoretically faces the risk of very large losses if the underlying moves against them.
- Option writers collect a premium in exchange for giving the buyer the right to buy or sell the underlying at an agreed price within an agreed period of time.
- A put or call can be covered or uncovered, with uncovered positions carrying much greater risk.
- Option writers prefer if options expire worthless and out-of-the-money, so they get to keep the entire premium. Option buyers want the options to expire in-the-money.
Understanding the Writer
Option buyers are given the right to buy or sell an underlying security, within a certain time frame, at a specified price by the option seller or writer. For this right, the option has a cost, called the premium. The premium is what option writers are after. They get paid upfront, but face high risk (if uncovered) if the option becomes very valuable to the buyer. For example, a put writer is hoping an underlying stock won't drop below the strike price, the buyer is hoping it will.The further below the put's strike price the underlying falls, the larger the loss for the writer, and the bigger the profit for the put buyer.
An option is uncovered when the writer does not have an offsetting position in the account. For example, the writer of a put option, who agrees to buy shares at the contract’s strike price, is uncovered if there is not a corresponding short position in their account to offset the risk of buying shares.
The writer faces potentially large losses if the options they write are uncovered. That means they don't own shares they write calls on, or don't hold short shares in the options they write puts on. The large losses can result from an adverse move in the underlying's price. With a call, for example, the writer is agreeing to sell shares to the buyer at the strike price, say $50. But assume that the stock, currently trading at $45, is offered a buyout by another company for $70 per share. The underlying instantly launch to $65 and oscillates there. It doesn't go to $70 because there is a chance the deal won't go through. The writer of the option now needs to buy shares at $65 to sell them at $50 to the option buyer, if the buyer exercises the option. Even if the option hasn't expired yet, the option writer is still facing a large loss, since they will need to buy the option back for roughly $15 more ($65 - $50) than they wrote it for to close out the position.
The primary objective for option writers is to generate income by collecting premiums when contracts are sold to open a position. The largest gains occur when contracts that have been sold expire out-of-the-money. For call writers, options expire out-of-the-money when the share price closes below the strike price of the contract. Out-of-the-money puts expire when the price of the underlying shares closes above the strike price. In both situations, the writer keeps the entire premium received for the sale of the contracts.
When the option moves in-the-money, the write faces a potential loss because they need to buy the option back for more than they received.
Covered writing is considered to be a conservative strategy for generating income. Uncovered or naked option writing is highly speculative because of the potential for unlimited losses.
Covered call writing generally results in one of three outcomes. When the options expire worthless, the writer keeps the entire premium they received for writing the option. If the options are going to expire in the money, the writer can either let the underlying shares be called away at the strike price or buy the option to close the position.
Called away means they need to sell their actual shares to the option buyer at the strike price, and the buyer will purchase the shares from them. Closing the option position, on the other hand, means buying the same option to offset the prior sold option. This closes the position and the profit or loss is the difference between the premium received and the price paid to buy the option back.
The outcomes of writing uncovered calls are generally the same with one key difference. If the share price closes in-the-money, the writer must either buy stock on the open market to deliver shares to the option buyer or close the position. The loss is the difference between the strike price and the open market price of the underlying (negative number), plus the premium initially received.
When a put writer is short the underlying stock, the position is covered if there is a corresponding number of shares sold short in the account. In the event that the short option closes in-the-money, the short position offsets the loss of the written put.
In an uncovered position, the writer must either buy shares at the strike price or buy the same option to close the position. If the writer buys the shares, the loss is the difference between the strike price and open market price, minus the premium received. If the writer closes the position by buying a put option to offset the sold option, the loss is the premium paid to buy minus the premium received.
Premium Time Value
Option writers pay especially close attention to time value. The longer an option has until the expiration, the greater its time value, because there is a greater chance it could move into-the-money. This possibility is of value to option buyers, and so they will pay a higher premium for a similar option with a longer expiry than a shorter expiry.
Time value decays as time passes, which favors the option writer. An out-of-the-money option that trades for $5 has time value because the option has no intrinsic value and yet it still trades for $5. If an option writer sells this option, they receive the $5. As time passes, as long as that option stays out-of-the-money, the value of that option will deteriorate to $0 at expiration. This allows the writer to keep the premium because they already received $5 and the option is now worth $0 and worthless once it expires out-of-the-money.
As an option gets near to expiry the main determinant of its value is the underlying's price relative to the strike price. If the option is in-the-money, the option value will reflect the difference between the two prices. If the option does expire in-the-money, but the difference between the strike price and the underlying's price is only $3, the option seller still actually makes money, because they received $5 and can buy back the position for $3, which is what the option will likely trade at near expiration.
Example of Writing a Call Option on a Stock
Assume that Apple Inc. (AAPL) shares are trading at $210. A trader doesn't believe that the shares will rise above $220 within the next two months, so they write a $220 strike price call option for $3.50. This means they receive $350 ($3.50 x 100 shares). They will get to keep that $350 as long as the option expires, in two months, when the price of Apple is below $220.
The writer may already own shares of Apple, or they could buy 100 shares at $210 to create a covered call. This protects them in case the stock shoots higher, say to $230. If this occurs, the writer would have to buy shares at $230 to sell to the option buyer at $220, losing them $650 (($10 - $3.50) x 100 shares). But if they owned the shares already they could just give them to the buyer at $220, make $1,000 on the share purchase ($10 x 100 shares) and still keep the $350 from the option sale.
The downside of the covered call is that if the share price drops, they get to keep the $350 option premium but they now own shares which are falling in value. If the shares fall to $190, the writer gets to keep the $3.50 per share from the option, but loses $20 per share ($2,000) on the shares they purchased at $210. Losing $16.50 ($20 - $3.50) per share is better than losing the full $20, though, which is what they would have lost if they bought the shares but didn't sell the option.