Risks Faced by the Option Writers
Writers of options are responsible for creating the option contract that are then bought on the exchanges.
When you are writing options, you have the commitment to buy or sell the stock should the option be exercised or assigned.
Before writing the option, it is prudent that they consider the worst theoretical loss that may be sustained.
To help understand the risks options writers face, below is a review of some of the most important risks they might encounter.
Short option positions are susceptible to margin calls.
Moreover, margin requirements can change and begin to cause the investor’s broker to issue a margin call.
Thus, an investor may be required to finish off the majority of his or her position as well as extra additional cash to cover the margin call.
The writers of call options are needed to deliver the stock upon being assigned.
In case the price of the underlying stock rise up to or above the call strike price, the option might be assigned.
On the other hand, if a writer of a call option does not own the underlying stock, the investor will have to purchase the shares in the open market.
The difference in the price at which the stock is obtained and the strike price of the assigned option can be significant, bringing about a substantial loss.
In the event that the investor has borrowed stock to meet this contractual obligation, the risk of further losses will be present.
When the writer owns the underlying stock, the exchange will assign the shares to a holder of the call option.
In this case, the option writer will no longer own these shares.
As a result, the writer of the option will hold the premium received for writing the call option.
Actually, this is the same case even when you have the straddle option.
Writers of covered calls suffer the loss of the right to the upside in the underlying stock.
A covered call writer gets the premium from the options and is covered by owning the underlying stock.
Nevertheless, if the price of the underlying stock falls, the call writer is merely covered by the premium on the options and will yet incur the loss in the stock price.
The writers of put options are obligated to take delivery of and pay for the underlying stock upon being allotted.
In the event that the price of the underlying stock fall down to or below the put strike price, then the options might be assigned.
After being assigned, the writer of a put options will be required to purchase the underlying stock at that option’s strike.
By being compelled to purchase the stock at the strike price, the put options writer may end up paying considerably more than the market price for the stock thus incurring a huge loss.
While the options writer will have gotten a premium from writing the options, this premium may be significantly not as much as the difference in the strike price and the market price of the underlying stock.
Category: Investing
