What it means
An option gives its buyer the right, but not the obligation, to buy or sell an asset at a set price, known as the strike price, before or on a set date. The writer is on the other side of that deal.
The writer receives the premium upfront and, if the buyer decides to use the right, must carry out the trade. There are two types.
Writing a call means promising to sell the asset at the strike price if the buyer asks, and writing a put means promising to buy it. In both cases the writer keeps the premium whatever happens, but the risk comes from the price moving against them.
A covered call is the best known conservative strategy. The writer already owns the shares and sells a call against them, earning premium income while accepting that the shares may be sold at the strike price.
A naked call, where the writer does not own the shares, carries potentially unlimited losses because a share price can rise without limit. Companies and investors write options for different reasons.
Some treasurers write options to earn premium income on assets they already hold, and some write puts to agree a price at which they would happily buy. Brokers require margin (cash or securities set aside as a guarantee) from writers, and this cost must be included in the return calculation.
The nuance is that the writer has limited upside and potentially large downside. The most the writer can earn is the premium, while the loss depends on how far the price moves.
Because of these risks, many companies restrict who can write options and set strict limits in their treasury policy.
In practice
Real-world examples.
Example
An investor owns 1,000 shares of a utility company and writes ten call contracts at a strike price above the current price. She collects premium income each quarter and is happy to sell if the shares reach the strike price.
Example
A pension fund writes put options on a stock it wants to buy. If the price falls to the strike price, it buys the shares at a price it had already decided was attractive, and if not it simply keeps the premium.
Example
A trader writes a naked call on a technology stock ahead of results, hoping the price will not move. The shares jump 30%, and the trader faces large losses and a margin call from the broker.
Formula
Calculation
Net result for call writer = premium received - (market price at expiry - strike price) x contract size, if the option is exercised
Suppose a writer sells one call contract on 100 shares with a strike price of $50 and receives a premium of $2 per share. Premium income = 2 x 100 = $200. If the share price rises to $60 at expiry, the buyer exercises and the writer loses (60 - 50) x 100 = $1,000 on the shares. Net result = 200 - 1,000 = -$800. If the share price stays below $50, the option expires worthless and the writer keeps the $200.Case study
Seen in the real world.
Meadowbank Capital is an illustrative, fictional family investment company holding 20,000 shares of a listed retailer, worth $40 each, or $800,000 in total. The CFO wanted extra income without selling the shares.
She wrote covered calls on the full holding with a strike price of $46, receiving a premium of $1.50 per share, or 1.50 x 20,000 = $30,000. If the shares stayed below $46, Meadowbank would keep the shares and the premium. If they rose above $46, it would sell at $46, giving up any further gain.
The shares rose to $52 and the calls were exercised. Meadowbank sold at $46 and kept the premium, but missed the gain between $46 and $52. In this illustrative case, the lesson was that writing options earns income in quiet markets and caps profits in strong ones.
Watch out
Common mistakes.
- Writing naked calls without understanding that losses can be very large if the price rises sharply.
- Counting the premium as pure profit, when the writer may have to buy or sell at a loss.
- Forgetting margin requirements and the cost of tying up cash or securities with the broker.
Questions
People also ask.
What is the difference between buying and writing an option?
A buyer pays a premium for a right and can lose only that premium, while a writer receives the premium and takes on an obligation with potentially larger losses.
What is a covered call?
It is a call sold on shares the writer already owns, so the shares can be delivered if the option is exercised.
Can a writer close the position early?
Yes, the writer can buy back the same option in the market, which ends the obligation at the then current price.
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