What is called the writing options?

India is witnessing an unprecedented rise in the number of retail investors that are looking to invest in various securities and multiply their wealth. Investors who are just starting can look towards equities and mutual funds while investors who have been active for a long time move a step ahead to invest in complex yet profitable securities. Such securities are introduced as bonds and derivatives that follow a complex structure to derive their prices and require deep knowledge of market factors to make a profit.

Between bonds and derivatives, investors with higher risk appetites lean towards the latter for portfolio diversification and to hedge against the losses of other asset classes. As derivatives have various asset classes, the diversification level multiplies along with the potential for profits.

This article details a factor called call writing options, which are a fundamental part of derivatives trading, explains what call writing means along with call writing strategies. But, the first step to understanding call writing options is to learn about derivatives.

What are Derivatives?

Derivatives are standardized financial contracts traded in stock exchanges in a regulated manner. They are subject to the rules framed by market regulators such as the Securities and Exchange Board of India (SEBI) in India or the Securities and Exchange Commission in the USA. They are essentially contracts, deriving values from the price fluctuations of their underlying assets such as stocks, commodities, etc.

These derivatives are traded through two methods: one that is subject to standardized terms and conditions, and hence being traded in the stock exchanges, and the second type being traded between private counter-parties, in the absence of a formal intermediary. While the first type is known as Exchange Traded Derivatives (ETDs), the second is known as Over Counter (OTC) derivatives.

What are the different types of derivatives?

There are two types of derivatives:

• Futures Contract: A futures contract is an agreement between the buyer and the seller of a particular asset. The buyers purchase a specific quantity of the asset at a predetermined price payable at a specific time in the future. This contract remains until maturity, and investors can sell them if the price has risen at the time of the expiry to make a profit.
• Options Contract: An options trading contract is generally permitted in top assets wherein the trader has the right but not a legal obligation to buy/sell the purchased security at a fixed price. Such a contract helps investors to make a profit based on price fluctuations without having to buy/sell the contract.

How do Options Contracts work?

Unlike a futures contract, options contracts are flexible as they do not force the options creator to go through with the contract. Investor can mitigate their losses if the underlying asset’s price goes below the contract price.

For example, let’s say you buy an options contract for purchasing 100 kgs of aluminum at Rs 20,000 payable after 3 months (expiration date). Since you have an options contract, you are expected to purchase the quantity before or after the expiration date. Now, if the price of aluminum goes down within three months, and the 100 kgs of aluminum are worth Rs 15,000, if you exercise your right to buy the contract, you would incur a loss of Rs 5,000. However, if the price goes up to Rs 25,000, you can exercise the right to buy and realize a profit of Rs 5,000.

Thus, under an options contract, you are not obliged to buy/sell the contract. Although, if you do not buy, you have to pay a premium to the seller for offering you the right for three months. This premium is the only loss you would incur if you decide not to buy the contract.

Types of Options Contract: The introduction of call options

There are two types of options contracts:

Call Options

A call option is a contract wherein you win the right, but not the obligation, to buy a certain underlying asset at a decided-upon price on a mutually decided date between the contracting parties. Since there is no obligation to purchase as dictated by the call option, you never need to execute it unless it is profitable to you.

The purchase can only be profitable if the previously decided-upon amount is lesser than the price of the stock on the date that the call option is meant to be executed. This predetermined price of the stock is called the strike price. Unless your strike price is lesser than the price of the stock on the date of execution, you will end up bearing losses through the call option.

Put Options

A Put option works exactly opposite to the call option. While the call option equips you with the right to buy, the put option empowers you with the right to sell the stock at the strike price on the date agreed upon by the contracting parties.

These contracts essentially revolve around the potential future value of the underlying asset. When you buy a put option, you are essentially attaining the right, but not the obligation, to sell a specified amount of the underlying asset at a specified price and on a specified date. This price decided upon through the contract is referred to as the strike price.

What is called writing options?

Think of call writing options as an enemy of call options where, if the buyer of an option (call options) makes a profit, the call options writer makes a loss.

As specified earlier, a call option is when a person has the right to buy but not the obligation. However, a call writing option is a process through which a seller sells the call option to the buyer. The seller, called the call writer, is obliged to sell the asset to the buyer if the right to buy is exercised. In the above example of options, the seller of 100 kg of aluminum is the call options writer, and you are the buyer. The only obligation you are under is to pay the call writer a premium, which is non-refundable.

The payoff for call writing options

Call writing options always end up in two of the following scenarios for the call writer and the call options buyer:

Scenario 1: The buyer exercises the right to buy.

As the buyer has the right to buy the underlying asset at the predetermined price, the call option contract may be bought by the buyer if the strike price (pre-determined price) is lower than the stop price (the current price). Since the call option writer is obliged to sell, the buyer will get the contract, and the call writer will get the premium.

Scenario 2: The buyer exercises the right not to purchase.

If the call option’s strike price is higher than the spot price, the buyer can exercise the right of not purchasing to avoid the losses. In such a case, the buyer’s payoff is zero as he will not be able to sell the contract. However, the buyer still has to pay the call writer a premium, which will be the only loss incurred for the buyer.

Benefits of call writing options

Here are the benefits of call writing options:

• Premium amount: The call options writer receives a premium immediately after the contract is agreed upon. Furthermore, the premium amount is non-refundable in case the buyer does not exercise the buying right.
• No risk: The call writer is exposed to negligible risk as a premium is provided for both of the scenarios mentioned above. Whatever the buyer decides, the call writer is provided with a predetermined premium.
• Time decay: It forces the price of options to fall, reducing the overall risk of the call options writer. The writer can buy back the contract at a lower price after selling it at a higher price to the buyer.
• Flexibility: Call Options writers have the flexibility to close out their open contracts at any time before the expiration date. The call options writers can remove their obligations by buying the written open from the secondary market.

Call writing options are a great way within the derivatives market to ensure you are protected on both sides of the transaction. Even if the buyer does not buy the contract, you can ensure that you mitigate risk through the premium amount and still have the options contract with you.

Furthermore, if you are an investor or are looking to invest in the derivatives market, you can look towards options to hedge against the risk of other asset classes and make a profit in the process. For every transaction that needs you to hold stocks, you would need a Demat and a trading account, best opened with IIFL. The Demat cum trading account gives you the benefit of seamless trading and investor-oriented research reports, allowing you to be a professional trader.