What is Option Writing? Who is an Option Writer in the Stock Market?

Option writing is like running an insurance business; you collect a premium upfront in exchange for taking on some level of risk. Just as an insurer earns money by covering potential claims, an option writer earns income by selling options contracts, agreeing to buy or sell an asset at a fixed price in the future. This strategy can help traders generate steady income while managing risk effectively.

In this article you will learn the option writing basics, how it works, and its benefits for traders.

What is Option Writing?

Option writing means selling option contracts that gives buyers the right (but not obligation) to purchase or sell underlying securities at a set price within a specific timeframe. Option writers take on market risks in exchange for immediate premium income.

Who is an Option Writer in the Stock Market?

An option writer, also known as a grantor, is a market participant who is obliged to honour the option contract in case the buyer exercises.

An option writer has the obligation against the buyer to deliver the underlying asset or purchase the underlying asset at a certain price before a specific date. They have primarily two main activities:

1. Writing call options: Giving buyers the right to purchase securities and option sellers the obligation to deliver the securities.
2. Writing put options: Giving buyers the right to sell securities and option sellers the obligation to purchase the securities.

Unlike regular traders who profit from market movements, option writers make money primarily from collecting premiums and time decay of options.

Objectives and Benefits of Call Writing

Call writing is a strategy where an investor sells a call option to generate income and manage risk. The primary objective is to collect premiums while limiting potential downsides. This strategy is particularly useful in sideways markets, where stock prices are expected to remain stable.

Stagnant Stock Scenario

• If the stock price remains flat or doesn’t rise significantly, the call writer benefits by keeping the premium collected.
• Investors use call writing when they believe the stock won’t move much in the short term, allowing them to generate income without selling the stock.

Premium Collection

• The main advantage of call writing is the ability to earn premium income upfront.
• If the option expires worthless, the writer keeps the entire premium as profit.
• This strategy works best when options expire out of the money (OTM)—meaning the stock price stays below the strike price.

Risk Mitigation in Covered Call Writing

• Covered call writing involves selling a call option while holding the underlying stock.
• This strategy helps reduce downside risk because the premium received acts as a cushion against small stock declines.
• However, if the stock price rises significantly, the writer may miss out on higher gains, as they are obligated to sell at the strike price.

Inverse Relationship

• Call writing and stock price movements share an inverse relationship in terms of risk and reward.
• If the stock price rises too high, the writer’s profit is capped, as they must sell at the agreed strike price.
• If the stock declines, the collected premium offsets some of the losses.

Diminishing Risks with Time

• Time decay, also known as theta decay, works in favour of call writers.
• As expiration approaches, the time value of the option decreases, benefiting the writer.
• If the stock stays below the strike price until expiry, the option expires worthless, and the writer keeps the full premium.

What are the Risks Involved in Option Writing

Option writing isn’t without significant risks. We will now discuss the major risks that are involved in options writing.

• The biggest concern is unlimited potential loss, especially with naked options (where you don’t own the underlying security).
• Market gap risk is another serious concern. Securities can sometimes make large moves overnight, leaving writers with substantial losses before they can adjust their positions. This is particularly dangerous with earnings announcements or other major news events.
• Margin requirements can also pose challenges. Since writing options requires maintaining margin deposits with your broker, sudden market moves might trigger margin calls, forcing you to either deposit more funds or close positions at a loss.
• Additionally, option writers face assignment risk. If an option moves deeply in-the-money, the buyer might exercise their right to buy or sell the underlying security, potentially forcing you into unfavourable positions.

Understanding these risks and rewards is crucial before starting option writing. Like any powerful tool, options need to be handled with knowledge, skill, and proper risk management strategies.

Example of Writing a Call Option on Stock

Let’s assume an investor owns 100 shares of ABC Industries, currently trading at ₹1,237.25 per share.

• The investor sells a call option with a strike price of ₹1,300 for a premium of ₹25 per share (total premium received = ₹2,500).

• Possible outcomes:

• 1. Stock stays below ₹1,300 (e.g., ₹1,280 or lower) → The option expires worthless, and the writer keeps ₹2,500 as profit.
  2. Stock rises above ₹1,300 (e.g., ₹1,350 or higher) → The call is exercised, and the writer must sell the shares at ₹1,300, missing out on any additional gains beyond that price.
  3. Stock declines (e.g., ₹1,180) → The investor still keeps the ₹2,500 premium, which helps offset part of the loss on the stock.

This example highlights how call writing helps generate income but also comes with the trade-off of limited upside potential if the stock price rises significantly.

Difference Between Option Buyer and Option Writer?

Think of the relationship between option buyers and writers as similar to that between insurance customers and insurance companies. The key differences lie in their rights, obligations, and risk-reward profiles.

Difference Between Call Writing and Put Writing

Call writing and Put writing can have different risk implications which traders must understand. We will now provide you a clear comparison of these two option writing strategies:

Conclusion

Option writing is a sophisticated income-generating strategy that requires careful risk management and market understanding. While it offers attractive benefits like regular premium income and time decay advantages, it also carries significant risks that must be properly managed.

Success in option writing comes from finding the right balance between premium collection and risk control, much like running a successful insurance business. Whether writing calls or puts, the key is to stay within your risk tolerance while maintaining consistent income generation.