Option writing

Posted by Jack Haddad on December 30, 2007 at 4:42 am

Writing an option, be it a call or a put, is different than purchasing. The fundamental difference in writing an option is that the decay in time value on the option works for you and not against you. For example, when you buy a call, you’d hope to sell it for a profit (higher than the purchase price) before the expiration of the option nears… Because, as the option nears expiration, the premium would decay (shrink) in value. Therefore, the underlying shares of the stock would have to move significantly higher to effect the option. However, when you write an option, the decay is beneficial for you because you must “buy back” or “buy to cover” the option at a lower price than the original purchase before expiration. Therefore, the decay on writing a call lowers the price for a “buy back.”

Now in writing options,there are two kinds: covered or naked. Covered option writing is when you purchase the underlying shares and simultaneously obtain (write) options against them. For example, if you bought 500 shares of INTC, then you would write 5 contracts of intc. In writing options, you initiate a transaction by choosing the “sell to open” and when closing the transaction, you would choose the “buy back to cover.” Naked options simply means when you carry more option contracts than the underlying shares. Each contract represents 100 shares. So, in the above example, any contract above 5 would be considered naked.

Personally, the type of option writing that I conduct is the “covered call option.” Occasionally, I write puts. However, calls are more predictable in either market direction and less influenced by the crooked MM (market maker). Market makers determine the price of options while the “specialist” determines the bid and ask of an underlying stock share.

Furthermore, options can be the following: 1. At the money (strike of the option equals the price of the underlying stock share), 2. Out of the money ( strike of the option being greater than the price of the underlying stock share), and 3. Deep in the money ( strike of the option being lower than the underlying stock share). “At the money” options will always pay the greatest premium compared to “deep” or “out” of the money options. When I think that the shares will surge and want to maximize as much upside as possible, I write “out of the money” calls. If a stock suggests stagnation in price, then I opt for the “at the money” options. “Deep in the money” options are a very interesting strategic play. I write them when i want to pocket the intrinsic value of the option while having my shares being called away at expiration. This particular sub-topic is really beyond the scope of this email. In sum, the intrinsic value of an option is the price of the purchased shares plus the option’s premium minus the strike of the option.

If youre confused, youre not alone. Options are an ocean of possibilities and complex strategies. You’ll learn best as you follow my trades; theyre something that you would absorb slowly.

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