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Introduction
Buying and selling of stock options is one of the most popular investment options in the financial markets. In the year 2008, according to Wong (2010, par. 2), stock options were one of the most undertaken activities in the New York Stock Exchange. This trend is baffling given the fact that considerable risks are associated with this form of trading. For example, the return on investment is not guaranteed.
An option holder stands the risk of losing the whole amount of the premium if the strike price is not attained. The entire principal that has been invested will thus be lost. The risk is even more amplified for the writer. For instance, if the investor writes an uncovered call, the potential loss is unlimited (Jagerson, 2009, par. 4). This is because this option puts no cap on the level that a stock price can rise. The gain for the writer is fixed, since there is no variation in the amount of premium paid. If the underlying price fluctuates in the wrong direction, the writer can lose a considerable amount of investment.
Advantages of Writing Options
Despite the above scenario, people continue writing options, as evidenced by the activity at various stock exchange firms in the country. One may then wonder why this is the case. Why, with knowledge on the risks that rides with such investments, would a seemingly rational investor continue writing options? The answer to this question can be found in the benefits and advantages of writing options.
Jagerson (2009, par. 3) opines that one of the benefits of writing options, as opposed to buying them, rests with the fact that majority of them are not exercised. If the option expires out of money, the buyer will not exercise it, since they stand to lose money (Caplan, 2008, p. 45). This being the case, the writer keeps the entire premium. According to Tucker (2007, par. 4), approximately eighty percent of options expire out of money, and are thus worthless. It is only in twenty percent cases that buyers exercise them. This makes he option very attractive to the writer.
Many investors engage in writing or selling options to get capital for their business. This is because premiums on options are not paid as down payments or in installments; rather, the whole amount is paid at the same time (Wong, 2010, par. 5). When the writer believes that the market prices will not get to strike price level within the period of the option, the money from the premium can be used to expand their business.
Hedging is another reason that makes investors to write options (Wreford, 2010, p. 82). Investors can write options as a way of safeguarding their investments. If they feel that the stock prices may fall beyond a certain point under which they will suffer a loss, they may write options which will act as a safe net (Wong, 2010). As such, negative effects of price fluctuations are averted without necessarily having to alter the underlying position.
The value of option declines as that of time melts (Jagerson, 2009, par. 5). This means that as expiry period neighs, liability and risk of the writer is reduced. Given that the writer had probably sold the option for a higher price, and had already taken the premium, they stand a chance to buy the same back at a lower price (Jagerson, 2009, par. 6). This makes it possible for the investor to exit the trade at their own volition, when they do wish.
Conclusion
Several reasons make it attractive for investors to write options despite the risks involved.
Some of these reasons include using options as a source of capital when the investor is sure of the fact that prices may not get to strike level. The fact that a considerable number of options under normal circumstances are not exercised makes it even more attractive. This is coupled with the fact that the risk to the writer declines as time melts. The investor is such able to hedge and safeguard their investments from market fluctuations.
References
Caplan, D. L. (2008). The new options advantages: Gaining a trading edge over the markets. New York: McGraw-Hill. Print.
Jagerson, J. (2009). Four benefits of selling options. Web.
Tucker, D. (2007). Option writing-Are the risks worth the rewards? Web.
Wong, G. (2010). Benefits of selling options premium. Web.
Wreford, T. (2010). “Options trading-Advantages and disadvantages”. Journal Of Investment, 34(3): 82.
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