Retail traders predominantly gravitate towards purchasing options when trading derivatives, as they are drawn to the "limited risk, unlimited reward" concept. On many occasions, you will find that professional traders or large institutional investors (known as "smart money") often have the option you planned on purchasing from the other side of the trade, in what is referred to as option writing.
If you've ever wondered how it is that the "house" always appears to win in the stock market, you are witnessing the power of option selling. The purpose of this guide is to give you an in-depth understanding of option writing, its purpose and objectives, and the various strategies that can be applied to it so that you can determine whether it aligns with your trading personality.
Learn Option Trading Strategies
What is Option Writing?
Option Writing (also known as option selling) is a method where an investor creates a new option contract and sells the contract to another party. The main difference between the person who is buying an option from you and the person you sold the option to is that the person buying the option will pay you a premium for the right to buy/sell a stock, while you, as the option writer, will receive the premium upfront, but you will also enter into an obligation.
When you are selling options, you are effectively acting as an insurance company where you have received a fee (premium) from the buyer, and you are now obligated to meet the terms of the option contract if the underlying security exceeds a predetermined strike price. To excel at this, understanding Equity Market Basics is essential, as option writing is deeply tied to the movement of underlying stocks.
Core Objectives of Option Writing
When traders write options, they have a specific intention behind each action. For example, by selling put options near monthly or weekly expiration dates on items that have a low probability of being exercised, traders can produce consistent income.
Another reason traders write options would be to take advantage of the fact that, as time passes, options decrease in value (i.e., are time-sensitive). The increase in value of a stock is reflective of an increase in the value of an option, while the drop in value of a stock is reflective of a decrease in the value of an option.
Traders also use options writing to hedge their investments against future losses. For example, if an investor sells a put option against a long stock, it indicates that the investor believes that the stock will not continue to increase in price, and thus creates a loss to their stock investment.
Traders also write put options to improve entry prices. Professional traders will frequently write put options on stocks that they want to eventually own (if and when the stock reaches a specific price), effectively allowing traders to make money while waiting for a better price to enter.
Join Our Advanced Options Trading Course
Types of Option Writing
For the purpose of organization, option writing can generally be categorized into two categories, based on whether there is owned stock or not:
1. Call Option Writing
When you write a call option, you are wagering that the underlying stock price will remain below the strike price.
Covered Call: The writer of the option owns the underlying stock and is effectively selling the call option against that stock. This is a more conservative way to generate income.
Naked Call: The writer of the option does not own the underlying stock, and therefore, the option writer carries a much greater risk. If the stock increases in value far beyond the strike price, there are potentially unlimited losses for the option writer if they are assigned.
2. Put Option Writing
You are betting that the stock price will remain above the strike price when you write a put option.
Cash-Secured Put: You have cash available to purchase the stock if it is put to you.
Naked Put: You are selling the put option on margin, with no cash securely backing it.
To determine which option to write, you must first understand the difference between a call option and a put option.
Check Out Option Greeks Trading Course
Benefits of Being an Option Writer
Why Would An Option Writer Take On An Obligation Rather Than A Right? The statistics are on the option writer's side.
Statistical Advantage: A research study has shown that a large percentage of options expire worthless, and since the option writer benefits from these options expiring worthless, the writer has a significant edge.
Three Directional Profits: When you buy an option, you only profit if the price moves sharply in one direction. If you write an option, you can profit if the stock moves up, stays the same, or moves down slightly.
Billions of Dollars (Theta): Time is the opposite of the option buyer but is the friend of the option writer. The option writer makes money just as the date on the calendar passes.
Adding Options Writing With Other Methods (Flexibility): You can add options writing to other trading strategies (successfully day trade) to improve overall return on investment (ROI).
Risks & Margin Requirements
When you begin trading options, there is no guarantee you will make a profit unless you put an amount of money into the business that requires significant amounts of capital.
Unlimited Risk
Although you will receive a premium when writing options, the risk involved with writing naked options has the potential to become significant. A market that opens at a large gap from where your position was established could cause you to lose more than you initially invested. This is why risk management in stock trading (along with the basic principles of risk management) is perhaps the most critical prerequisite to writing options.
Margin Requirements
Writing an option requires a margin to be maintained in your trading account. The exchanges, such as NSE, require that you maintain an adequate amount of cash (margin) as a security deposit in your trading account so that they are assured of your ability to meet your obligations when they arise.
Through the use of option chain analysis when you are looking for intraday trading opportunities, you will be able to find "safe zones" where there is less than a 50% chance that prices will reach either of the strike prices.
Practice With Options Trading Mock Test
Option Writing vs Option Buying
If you would like to take the next step toward gaining more technical knowledge of derivatives trading in India, the next step in your studies would be the topic of how to begin trading options.
Conclusion
The option process is an advanced method to improve your betting odds. Instead of gambling and hoping for a winner, you are betting on the future value of a stock, which is based on time decay and high-probability trends, thus transitioning you from being a gambler to being an income provider.
Be sure to keep your position sizes manageable and have a stop loss on each option position. Always be mindful of the risks associated with option trading.
For those serious about making a career in this area, I would recommend you take the NISM Series VIII exam, using a NISM Series 8 Mock Test to help you prepare for it and increase your understanding of the Greeks as they relate to derivatives.
.jpg)
.jpg)
-–-full-preparation-strategy-for-high-marks.png)
-work.jpg)
