Option writer
Also written Writer of an option · Option seller · Seller of an option
The party who sells an option: receives the premium upfront and takes on the obligation to sell (call) or buy (put) the underlying if the buyer exercises. Gain is capped at the premium.
In plain language
Every option has two sides. The buyer pays a premium and gets a right. The writer collects that premium and takes on the matching obligation.
The buyer only exercises when it suits the buyer. So the writer's best outcome is known on day one: keep the premium when the option expires worthless. The worst outcome is whatever the buyer's gain turns out to be.
That asymmetry is the whole character of option writing. Small, likely, capped gains; larger, less likely, open-ended losses. Writers are paid for carrying that risk, which is why the workbook notes they "tend to extract higher premiums" when volatility is expected to be high.
How it works
The workbook's definitions (Chapter 16):
- The party taking a short position, selling the option, is the seller or writer. The buyer pays the premium to the writer upfront.
- "The writer of an option is one who receives the option premium and is thereby obliged to sell/buy the asset if the buyer of option exercises his right." A sell obligation for a call; a buy obligation for a put.
- The writer "is legally bound to honour the contract whenever the option buyer decides to exercise".
- Assignment is the allocation of exercised options to one or more option sellers.
- A closing purchase reduces or eliminates a short position and is often called "covering" it. It must be in an option with the same strike and same expiry.
Views: a call writer is neutral to bearish; a put writer is neutral to bullish.
Pay-off: the writer's gain is limited to the premium; Chapter 21 says the seller "faces unlimited risk" and has "limited upside equal to the premium received". For a call the loss is indeed open-ended. For a put the loss is bounded, because the underlying cannot fall below zero: the Chapter 16 sample question (put strike Rs 245, premium Rs 49) gives a maximum loss of 245 − 49 = Rs 196.
When writers prefer to sell: when implied volatility is high, because the option price itself is high. And the delta is used to hedge a share holding by writing calls: n shares ÷ delta gives the number of calls to write for a delta-neutral position.
The formula
Short call pay-off at expiry = Premium − max(0, S − X)
Short put pay-off at expiry = Premium − max(0, X − S)
Maximum gain (either) = Premium
Maximum loss, short call = unlimited
Maximum loss, short put = X − Premium (if S falls to zero)
Break-even, short call = X + Premium
Break-even, short put = X − Premium
S = underlying price at expiry, X = strike.
A worked example
The workbook's Chapter 16 call-seller table, with the index at 17,562, uses a 17,500 strike call at a premium of 185. Take the workbook's own assumed Nifty lot size of 50.
Premium received = 185 × 50 = Rs 9,250
Break-even = 17,500 + 185 = 17,685
| Index at expiry | Per unit | Per lot of 50 |
|---|---|---|
| 17,300 or below | +185 | +Rs 9,250 |
| 17,600 | 185 − 100 = +85 | +Rs 4,250 |
| 17,700 | 185 − 200 = −15 | −Rs 750 |
| 18,000 | 185 − 500 = −315 | −Rs 15,750 |
The gain never exceeds Rs 9,250. The loss at 18,000 is already 1.7 times the most the writer could have made, and it keeps growing with the index.
Now the put side, from the Chapter 16 sample question: write a put with strike Rs 245 at premium Rs 49. If the share collapses to zero:
Loss = (245 − 0) − 49 = Rs 196 per share
Large, but finite. That is the difference between the two kinds of writing.
Why NISM asks about it
Chapter 16 (Introduction to Options) defines the writer, assignment and closing transactions and gives the seller-perspective pay-off tables for calls and puts; Chapter 17 builds short straddles, short strangles and covered calls from written options; Chapter 21 (Exchange Traded Interest Rate Options) restates the buyer-versus-seller risk. Expect a maximum-loss calculation for a written put, a question on which view a call or put writer holds, and one on who carries the obligation.
Common exam traps
- The writer has the obligation; the buyer has the right. Options reversing this are the commonest wrong answers.
- Call writer: obligation to sell. Put writer: obligation to buy.
- Unlimited loss is true for a short call, not a short put. Chapter 21 speaks of the seller facing unlimited risk in general terms; the Chapter 16 sample question shows a written put's maximum loss is strike minus premium.
- Maximum gain is the premium, whatever happens to the underlying.
- Covering a short option means buying the same strike and expiry. Buying a different option is a new position, not a close.
- Selling deep ITM puts fetches more premium and carries more risk; deep OTM puts are less risky and pay less (Chapter 16).
Where this is taught
- Series IV · Chapter 4: Exchange Traded Interest Rate Optionsintroduced here
- Series XXI-B · Chapter 5: Derivativesintroduced here
- Series V-D · Chapter 16: Introduction to Optionsintroduced here
- Series XXI-A · Chapter 5: Derivativesintroduced here
- Series V-D · Chapter 21: Exchange Traded Interest Rate Options
Related terms
- Break-even pointThe level of the underlying at which a position makes neither profit nor loss — for a bought call, strike plus premium; for a bought put, strike minus premium.
- AssignmentThe allocation of exercised options to one or more option sellers — the moment the writer's obligation becomes a real cash outflow, decided by the exchange and not by the writer.
- Implied volatilityThe volatility figure that, put into an option pricing model, reproduces the option's actual market price — the market's consensus forecast of how much the underlying will move.
- OptionA contract giving the buyer the right, but not the obligation, to buy or sell the underlying at a stated price on or before a stated date, in exchange for a premium paid to the writer.
- Covered callHolding the underlying in the cash market and writing a call against it — a way of earning premium income from a holding, at the cost of capping the gain above the strike.
- Short straddleSelling a call and a put with the same strike and same expiry, betting the underlying stays still. Profit is capped at the two premiums; losses grow without limit on a big move either way.
- Short strangleSelling an out-of-the-money call and an out-of-the-money put on the same underlying and expiry. It profits if the price stays between the two strikes; losses are unlimited on a large move.
- Naked putIn this workbook, a put option taken for trading or speculation with no portfolio behind it — the counterpart of a protective put, which insures holdings the investor already owns.
- Asymmetric risk exposureThe defining pay-off feature of options: gains when the underlying moves one way differ sharply from losses when it moves the other way. Futures, by contrast, have symmetric exposure.
- Covered short putWriting a put option while holding enough funds to buy the commodity if the put is exercised — a premium-earning strategy, as opposed to a naked short put written without the funds.
- Closing transactionAn options trade that reduces or eliminates an existing position by an offsetting purchase or sale of a contract with the same strike price and expiry — also called squaring off.
- American optionAn option whose holder may exercise it at any time on or before expiry. All exchange-traded index and stock options in India are European style instead — exercisable only on expiry.
- Short positionAn outstanding, unsettled sell position in a derivatives contract — the seller of a futures contract, or the seller (writer) of an option, is said to be short.
- Asymmetric payoffA payoff where gains when the underlying moves one way differ sharply from losses when it moves the other — the defining feature of options, as against the symmetric, linear payoff of futures.
- Delta hedgingOffsetting an option position's delta with the underlying or futures so the combined delta is zero, then buying or selling as delta changes to keep it there — the option trader's way of managing risk.