Option Writer

An Option Writer (also known as an 'Option Seller') is the party in an option contract who creates and sells the contract to a buyer. In doing so, the writer collects an upfront cash payment known as the premium. This premium is the writer's to keep, no matter what happens next. In exchange for this fee, the writer accepts a binding obligation: they must either buy (if they wrote a put option) or sell (if they wrote a call option) an underlying asset, such as a stock or an ETF, at a predetermined price (the strike price) if the option buyer decides to exercise their right before the expiration date. You can think of an option writer as being similar to an insurance company. They analyze probabilities and collect a premium for taking on a specific risk for a defined period. The writer's profit is limited to the premium they receive, but their potential loss can be substantial if the market moves sharply against their position.

At its core, writing options is a strategy that profits from the passage of time and market probabilities. The primary motivation for a writer is to collect and keep the premium. They are essentially betting that the option they sold will expire worthless, meaning the underlying asset's price doesn't reach a point where the buyer would want to exercise the contract. Since a majority of options do expire without being exercised, this can be a consistent income-generating strategy. The writer profits from a concept known as theta decay, which is the rate at which an option's value erodes as its expiration date draws closer. Every day that passes without a significant price move in the “wrong” direction is a small victory for the option writer.

An option writer's obligation depends entirely on the type of option they sell. There are two fundamental types: calls and puts.

A call writer sells someone the right to buy an asset from them at the strike price. The writer is obligated to sell the asset if the market price rises above the strike price and the buyer exercises the option. This is typically a neutral to slightly bearish position on the asset's short-term prospects.

• The Covered Call Writer: This is a popular and relatively conservative strategy. A writer of a covered call already owns the underlying shares they are obligated to sell. For long-term investors, this is an excellent way to generate extra income from stocks they already hold. The main risk isn't a financial loss but an opportunity cost—if the stock price soars far above the strike price, the writer misses out on those extra gains because they are forced to sell at the lower strike price.
• The Naked Call Writer: This is an extremely high-risk strategy that is not recommended for ordinary investors. A writer of a “naked” or “uncovered” call does not own the underlying shares. If the stock price skyrockets, their potential loss is theoretically unlimited as they must buy the shares on the open market at a very high price to deliver them at the low strike price.

A put writer sells someone the right to sell an asset to them at the strike price. The writer is obligated to buy the asset if the market price falls below the strike price and the buyer exercises the option. This is typically a neutral to bullish position, as the writer expects the asset's price to stay above the strike price.

• The Cash-Secured Put Writer: This is a favorite strategy of many value investors. A writer of a cash-secured put has enough cash set aside to purchase the shares if the option is exercised. There are two great outcomes:
  1. 1. The stock price stays above the strike, the option expires worthless, and the writer keeps the premium as pure profit.
  2. 2. The stock price falls below the strike, and the writer is “forced” to buy a stock they already wanted to own, but at a discount. Their effective purchase price is the strike price minus the premium they received, lowering their cost basis.
• The Naked Put Writer: This involves writing a put without having the cash to buy the shares. While the maximum loss is capped (the strike price x 100, if the stock goes to zero), it is still a very risky strategy that can lead to major losses.

For a value investing practitioner, writing options is not about speculation; it's a powerful tool for disciplined income generation and strategic stock acquisition. The key is to detach from the speculative mindset and focus on the underlying business. A value investor only writes options on high-quality companies they have already researched and would be happy to own for the long term.

• Writing cash-secured puts allows you to set the price at which you'd love to buy a great company, and then get paid while you wait for the market to bring the stock to you.
• Writing covered calls on your long-term holdings can provide a steady stream of income, enhancing your total return while you wait for the company's value to compound.

The golden rule for a value investor is simple: Never write an option that would force you to buy a stock you don't want or sell a stock you aren't ready to part with at the agreed-upon price. Approached with this discipline, option writing becomes a valuable addition to the investor's toolkit.