Call Writing and Put Writing
Call Writing and Put Writing: Detailed Explanation
Call Writing and Put Writing are strategies used in options
trading, a part of derivatives trading. To understand them fully, let’s break
them down.
1. What is Options Trading?
Options are financial contracts that give the buyer the
right, but not the obligation, to buy or sell an underlying asset (like stocks,
commodities, or indices) at a predetermined price (called the strike price)
before or on a specified date (the expiry date).
- Call
Option: Gives
the buyer the right to buy an asset.
- Put
Option: Gives
the buyer the right to sell an asset.
Now, there are two sides to every option trade:
- Buying
an Option:
Paying a premium to purchase the right to buy/sell the asset.
- Writing
(Selling) an Option: Taking the responsibility to sell/buy the asset if the buyer
exercises the option.
2. Call Writing
Call Writing (or Selling a Call) is when an individual sells a call
option contract. The seller, known as the call writer, is obligated to
sell the underlying asset to the call buyer if the buyer decides to exercise
the option (usually when the asset price is above the strike price).
Types of Call Writing:
- Covered
Call: The call
writer owns the underlying asset. This strategy is used to generate
additional income on assets the writer already owns.
- Naked
(Uncovered) Call:
The call writer does not own the underlying asset. This is riskier, as the
writer may have to buy the asset at a higher market price if the option is
exercised.
Example of Call Writing:
- You
sell a Call Option for Stock XYZ with a strike price of $100 and
collect a premium of $5 per share (each option typically represents 100
shares, so total premium = $500).
- If
the stock stays below $100, the buyer won’t exercise the option, and you
keep the $500 premium as profit.
- If
the stock rises above $100, the buyer will exercise the option, and you
are obligated to sell XYZ at $100 (even if it’s trading at $110 or more),
potentially incurring a loss if you don't already own the stock.
Key Points:
- Profit: The premium received from
selling the call.
- Risk: If the stock price rises
sharply, your losses can be significant because you’ll have to sell the
stock at the strike price (if you don’t own the stock, you’ll have to buy
it at the market price first, which could be much higher).
3. Put Writing
Put Writing (or Selling a Put) is when an individual sells a put option
contract. The seller, known as the put writer, is obligated to buy the
underlying asset from the put buyer if the buyer exercises the option (usually
when the asset price is below the strike price).
Types of Put Writing:
- Cash-Secured
Put: The put
writer has enough cash in their account to buy the underlying asset if the
option is exercised. This is a common strategy for acquiring stocks at a
discount.
- Naked
(Unsecured) Put:
The put writer does not have enough cash to cover the purchase of the
asset. This is a riskier strategy since it requires the writer to have
enough liquidity in case the option is exercised.
Example of Put Writing:
- You
sell a Put Option for Stock XYZ with a strike price of $100 and
collect a premium of $5 per share (total premium = $500).
- If
the stock stays above $100, the option expires worthless, and you keep the
premium.
- If
the stock falls below $100 (e.g., to $90), the buyer exercises the option,
and you are obligated to buy XYZ at $100, even though the market price is
lower.
Key Points:
- Profit: The premium received from
selling the put.
- Risk: If the stock price drops
sharply, you could be forced to buy the stock at a price higher than the
market price, leading to a potential loss.
4. Comparison of Call Writing and Put Writing
Feature |
Call Writing |
Put Writing |
Obligation |
Sell the asset if option is exercised |
Buy the asset if option is exercised |
When Profitable |
When the asset price stays below the strike price |
When the asset price stays above the strike price |
Risk |
Losses if the asset price rises sharply |
Losses if the asset price falls sharply |
Strategy Objective |
Income generation, hedge positions |
Acquiring stock at a discount or generating income |
Maximum Profit |
Premium received |
Premium received |
Maximum Loss |
Unlimited (if uncovered) |
Limited to the strike price minus premium |
5. Example:
Call Writing Example:
- Stock
XYZ is currently trading at $95.
- You
sell a call option with a strike price of $100 and receive a $5 premium.
- If
XYZ remains below $100, you keep the $5 premium.
- If
XYZ rises above $100 (let’s say $110), you are forced to sell the stock at
$100, missing out on the $10 price rise.
Put Writing Example:
- Stock
XYZ is currently trading at $105.
- You
sell a put option with a strike price of $100 and receive a $5 premium.
- If
XYZ remains above $100, you keep the $5 premium.
- If
XYZ drops below $100 (let’s say to $90), you are forced to buy the stock
at $100, incurring a $10 per share loss (offset slightly by the $5
premium).
Conclusion:
- Call
Writing is best
for generating income in a neutral to slightly bearish market, but has
significant risks in a bullish market if uncovered.
- Put
Writing is used
to either buy stocks at a discount or generate income in a neutral to
slightly bullish market, with risk coming from sharp market declines.
Both strategies are commonly used by investors and traders
for income generation or for entering stock positions at favorable prices, but
they require careful risk management.
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