So you’ve decided you want to use options in trading, but should you take the safe route of buying them, and only having a position in the underlying security if the market moves the direction you hoped? Or should you take the riskier route and be an option seller?
Selling options, sometimes also called writing options, is indeed riskier than buying them. An option buyer will only ever have a market position if it’s profitable. An option seller will only ever be assigned a market position if it’s a loss… and they can sometimes be quite a loss. The best thing that can happen to an option seller is that the option never moves in-the-money and it never gets exercised and it expires worthless.
Perhaps the easiest way to think about writing options is to compare it to writing an insurance policy. An insurance company accepts a premium from his customer, and if a certain condition happens (the customer’s car gets wrecked or the customer’s house burns down), the insurance company must honor its policy and pay for the damage. The insurance company surely hopes those conditions never happen, because then it could keep that customer’s premium along with the premiums of all its other customers.
Option sellers are similar, and the language of using options in trading is similar, too: the buyer pays the seller a “premium.” An option seller sold a put or call at some premium value, so if the option expires worthless, he never has to buy it back or deliver the underlying security, and he gets to keep the full premium he received at the time he sold it. The seller can also get out of the option before it expires by buying it back and either profiting or losing on the change in premium value.
The premium value tends to change as the underlying security’s value changes, and it tends to decay the closer the option gets to expiration, and it tends to rise and fall as the volatility of the underlying market rises and falls, and it is also a function of the risk-free interest rate and any dividends of the underlying security. Because an option seller wants to sell high and buy low, just like any other trader, he must track those factors closely, in case the premium of the option he sold actually rises and he ends up holding a losing premium position.
When it comes to in-the-money options, however, an option seller can minimize his risk by writing “covered” puts or calls, wherein he sells or buys the underlying security before the option is exercised to hedge himself from being assigned a losing position in the underlying security. This would be similar to the insurance company in our example buying its own policy from a reinsurance company.
But the biggest profits from option writing come from writing “naked” (unhedged) options and writing lots of them. These are very risky practices, so you can see how in the world of using options in trading, the option writer is a very bold soul.
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