Writing Call Options | Payoff | Example | Strategies

Learn about the four basic option strategies for beginners. Not only will you generate the profit from option writing, but also you will generate the return each year from your Treasury bills. It can be deployed in a wide variety of market conditions and has a magical effect on boosting your premium: Selling more time can be a slow path to higher returns. This process is similar to compounding interest in your bank account, except the return is much better! However, he does not wish to increase his portfolio as of now. Set a Bailout Point and Use It A bailout point is the price, or the point in your strategy, at which you wish to buy back your naked positions in order to limit your losses.

Sep 30,  · Writing options is one of those strategies that is easy to understand but infinitely more difficult to master. Option selling, especially in commodities, has its own set of risks.

Reader Interactions

In this article, we discuss writing put options as to different strategies involved in writing, their benefits and drawbacks, margin requirement etc. As we know that put option gives holder the right but not the obligation to sell the shares at a predetermined price. Whereas, in writing a put option, a person sells the put option to the buyer and obliged himself to buy the shares at the strike price if exercised by the buyer.

The seller in return earns premium which is paid by the buyer and committing to buy the shares at strike price. Thus in contrast to the call option writer, the put option writer has a neutral or positive outlook on the stock or expects a decrease in volatility.

XYZ has sold one lot of put option to Mr. XYZ writer of put option. Therefore, selling or writing put can be a rewarding strategy in a stagnant or rising stock.

Please note that this is only for 1 stock. A put option gives the holder of the option the right to sell an asset by a certain date at a certain price. Hence, whenever a put option is written by the seller or writer it gives payoff of zero since the put is not exercised by the holder or the difference between stock price and strike price, whichever is minimum.

As the name suggest, in writing covered put strategy, the investor write put options along with shorting the underlying stocks. This Option Trading strategy is adopted by the investors if they strongly feel that stock is going to fall or to be constant in near term or short term.

The net payoff for the writer here is premium received plus income from shorting the stocks and cost involved in buying back those stocks when exercised. Therefore, there is no downside risk and the maximum profit than an investor earn through this strategy is the premium received. On the other hand, if prices of underlying stocks rise, then the writer is exposed to unlimited upside risk as stock price can rise to any level and even if the option is not exercised by the holder, the writer has to buy the shares underlying back because of shorting in spot market and the income for writer here is only the premium received from the holder.

With our above argument, we can view this strategy as limited profit with no downside risk but unlimited upside risk. The pay-off diagram of covered put option is shown in image The best way to project this type of price behavior is to look at the underlying trend of each of the optionable stocks.

Never buck a strong uptrending stock, or in Wall Street parlance, "Don't fight the tape. While the option buyer always hunts and pecks for options on stocks that are extremely volatile, the option writer loves stocks that don't move anywhere.

He wants stocks that move slowly, and ones that move in a narrow range, because the option writer always has time working in his favor.

The slower a stock price moves, the more money he makes. Options with slow-moving underlying stocks will depreciate to zero before the stock ever reaches the bailout point. Unfortunately, the stocks with the highest volatility maintain the highest and fattest premiums for option writing, and so the option writer must attempt to find options with low volatility, and correspondingly high premiums time values when possible.

Naked option writing, with its extreme risks, requires diversity. You should maintain at least four different option positions with different underlying stocks. Remember, one of your overall goals is to stay in the game, and the best way to do that is to avoid betting all your money on one horse.

Although the odds are heavily in your favor, losers can put you out of the game if everything you have is bet on that one position. Finally, maintain very small positions in each stock so that a takeover does not nail you with a devastating loss.

The only options you should consider as writing candidates are those with no real intrinsic value, that are not in the money. Use only those options that are out of the money, which only have time extrinsic value. Furthermore, you should select options that are significantly out of the money, so that it will take a strong move in the stock—a move that normally would not occur in a two- or three-month time period see number seven —to hit your bailout parameters.

These out-of-the-money options have a low probability of ever being exercised, or of ever having real value, and this low probability is a strong advantage to the naked options writer.

In other words, choose to sell options that have the highest probability of expiring before the stock price ever gets close to the strike price.

Remember that as an option approaches expiration, its rate of depreciation normally increases, especially in the last month. Consequently, these are the times to write naked options. You will receive a higher rate of premium in the last three months of the option than at any other time in its life. The shorter the time before expiration, the better.

One of the most important secrets to successful naked option writing is to only write options that have been overpriced by the market, i. This will add insurance to your profit potential and is an important key to successful option writing. When writing options, you must put up a margin requirement.

The margin requirement can be in the form of cash or securities. It can be also be in the form of Treasury bills. If it is the form of securities, you can only use the loan value of the securities. However, Treasury bills are treated just like cash, and this is one major advantage of using them.

Not only will you generate the profit from option writing, but also you will generate the return each year from your Treasury bills. Most brokerage houses place your credit balances in the money market, so you will still earn interest if don't have Treasury bills. Watch your stock and option prices like a hawk during the periods of time that you are holding these naked options positions.

The professional naked options writer will keep a close eye on the price action of the underlying stock, and will cover a position, bail out of a position, or buy back a position if there is a change in the trend of the underlying stock. He will also take profits early when the option shrinks in value quickly because of an advantageous stock price move. Or he may take action when the options become extremely undervalued, according to the stock price.

Breaking Down 'Writing An Option'

Jan 31,  · Seven ways to collect higher option premiums. By James Cordier, an investment firm specializing in writing commodities options for high net-worth . In this article on Writing Put Option, we discuss what they are, different strategies involved in writing, Payoffs, benefits & drawbacks, margin requirement. In this article, the performances of common portfolio option writing strategies are analyzed against their historical performance from to From this a.