How to Write Options: A Detailed Look at Calls and Puts

Options writing involves selling options contracts to collect premiums, offering traders a way to generate income or hedge positions. However, it carries significant risk, as the writer may be required to buy or sell an asset at an unfavorable price. Understanding how calls and puts work is essential before engaging in this strategy.

Different approaches to writing options come with varying levels of risk and reward. Choosing the right strike price and premium affects profitability, while settlement and tax implications also play a role.

Requirements and Eligibility

Brokerage firms impose specific requirements before allowing traders to write options, primarily to manage risk. Investors must apply for options trading approval by completing a questionnaire that evaluates their financial situation, investment experience, and risk tolerance. Brokerages categorize traders into different levels, with writing uncovered options requiring the highest level due to the potential for unlimited losses.

Margin accounts are typically required for writing uncovered options, as they provide leverage and ensure the trader can meet potential obligations. The Financial Industry Regulatory Authority (FINRA) and the Options Clearing Corporation (OCC) set minimum margin requirements, but brokerages often impose stricter rules. For example, writing a naked call may require maintaining a margin balance equal to a percentage of the underlying asset’s value plus the premium received.

Regulatory compliance extends beyond margin requirements. The SEC mandates that brokerages provide traders with the “Characteristics and Risks of Standardized Options” document to ensure they understand the complexities involved. Some firms also require traders to have prior experience buying options before granting approval to write them.

Types of Option Writing

Writing options can be done in different ways, each with its own risk and reward characteristics. Some strategies involve holding the underlying asset to reduce exposure, while others rely on margin to cover potential losses.

Covered Calls

A covered call involves selling a call option while owning the underlying stock. This strategy generates income from the premium received but limits potential gains if the stock price rises above the strike price. Since the writer already owns the shares, the risk is lower compared to selling a naked call.

For example, if an investor owns 100 shares of a stock trading at $50 and sells a call option with a $55 strike price for a $2 premium, they collect $200. If the stock remains below $55, the option expires worthless, and the investor keeps both the shares and the premium. If the stock rises above $55, the investor must sell at that price, potentially missing out on further gains.

This strategy is often used to generate additional income from stocks already owned. However, it caps upside potential, making it less suitable for those expecting significant price appreciation.

Naked Calls

A naked call, or uncovered call, involves selling a call option without owning the underlying asset. This strategy carries significant risk because if the stock price rises above the strike price, the writer must buy shares at the market price to fulfill the contract, potentially incurring unlimited losses.

For instance, if a trader sells a call option with a $60 strike price for a $3 premium and the stock rises to $80, they must buy shares at $80 to sell them at $60, resulting in a $1,700 loss per contract. If the stock continues to rise, losses can grow indefinitely.

Due to the high risk, brokerages require significant margin to write naked calls. This strategy is typically used by experienced traders who anticipate little movement in the stock price or expect it to decline.

Cash-Secured Puts

A cash-secured put involves selling a put option while holding enough cash to buy the underlying stock if assigned. This strategy is often used by investors looking to acquire shares at a lower price while earning income from the premium.

For example, if a trader sells a put option with a $40 strike price for a $2 premium, they collect $200 upfront. If the stock stays above $40, the option expires worthless, and they keep the premium. If the stock falls below $40, they must buy 100 shares at that price, effectively purchasing them at a net cost of $38 per share.

This approach is considered less risky than writing naked puts because the trader has the cash to cover the purchase. However, if the stock price drops significantly, they may end up buying shares at a higher price than the market value.

Strike Price and Premium Selection

Choosing the right strike price and premium is essential when writing options, as it directly affects risk, potential returns, and the probability of assignment. The strike price determines the level at which the option can be exercised, while the premium received represents the immediate income collected by the writer. Both factors are influenced by market conditions, time to expiration, and the volatility of the underlying asset.

Higher volatility generally leads to higher premiums, as there is a greater likelihood of significant price movement before expiration. Stocks with frequent price swings or upcoming earnings announcements tend to have more expensive options, offering greater income potential but also increasing the risk of assignment. Writing options on stable stocks with low implied volatility results in lower premiums but provides a higher probability of the option expiring worthless.

Time value also plays a role in determining premiums. Options with longer expirations typically command higher premiums due to the extended period for the underlying asset to move in the money. However, this also means the writer remains exposed to market fluctuations for a longer duration. Shorter-term options decay faster, benefiting the writer if the price remains stable, but they offer lower premiums.

Selecting an appropriate strike price involves balancing risk and reward. Writing options with strike prices closer to the current market price provides higher premiums but increases the likelihood of assignment. Out-of-the-money options offer lower premiums but provide a greater margin of safety. Some traders prefer writing options slightly out of the money to maximize income while reducing the chances of being assigned, while others choose deeper out-of-the-money strikes for a more conservative approach.

Settlement and Execution

Once an option is written, settlement procedures and execution mechanics determine how obligations are fulfilled. American-style options can be exercised at any time before expiration, introducing unpredictability for option writers. Early assignment can occur based on dividend schedules, interest rate changes, or sudden price movements. European-style options only allow exercise at expiration, offering more certainty in managing positions.

If an option is exercised, the Options Clearing Corporation (OCC) randomly assigns the obligation to a writer holding a short position in that contract. This process ensures fairness but means that individual traders cannot predict when or if they will be assigned. Writers of in-the-money options must be prepared to either deliver the underlying asset in the case of calls or purchase it in the case of puts. For cash-settled options, such as index options, the writer pays or receives the difference between the strike price and the settlement value rather than exchanging the underlying asset.

Tax Considerations for Option Writers

Tax treatment for option writers varies based on the type of option, holding period, and whether the contract is exercised, expired, or closed before expiration. The IRS categorizes options as capital assets, meaning gains and losses are typically subject to capital gains tax rules.

If an option expires worthless, the premium received is considered a short-term capital gain, regardless of how long the contract was open. The IRS treats the premium as income realized at expiration. For example, if a trader writes a put option for $500 and it expires unexercised, that $500 is taxed as short-term capital gains. If the option is bought back before expiration at a lower price, the difference between the premium received and the repurchase cost is considered a capital gain or loss.

When an option is exercised, tax treatment depends on whether it was a call or put. If a written call is exercised, the premium received is added to the sale price of the underlying asset, adjusting the capital gain or loss. For instance, if a trader sells a covered call at a $50 strike price and receives a $3 premium, the effective sale price becomes $53. If the shares were originally purchased at $40, the taxable gain is based on this adjusted amount. For put options, the premium lowers the cost basis of the acquired shares. If a trader is assigned a put at $60 and received a $4 premium, their cost basis becomes $56 per share. This impacts future capital gains calculations when the stock is eventually sold.