Understanding Option Writing: A Delicate Balance
The question often arises: if 75% of all options held to expiration expire worthless according to the Chicago Mercantile Exchange (CME), why aren’t more traders becoming option writers instead of buyers? The answer lies in a combination of risks and strategies, as well as the intricate nature of options trading.
The Pros of Being an Option Writer
For many professionals, the allure of option writing is in its potential profitability, especially in high-volatility environments. By making smaller bets and employing defensive strategies, option writers can manage their portfolios effectively. Holding a negative delta portfolio is a key strategy to counterbalance the effects of increased volatility, ensuring that even if the option sale goes against them, their overall portfolio remains stable.
It's important to note, however, that one must never buy options unless it is part of a larger selling strategy. Time decay, or theta, is an ever-present risk in options trading. Even if an option is initially profitable, the decline in value as expiration approaches can be significant, leading to substantial losses if not managed carefully.
The Risks of Option Writing
The realm of option writing is not without its challenges. Several factors make it a less attractive proposition for many traders:
The Need for Heavy Margin
Being an option writer demands a significant amount of margin, which is not something every trader can afford. High initial capital requirements and the stringent risk management involved can be daunting, especially for those just starting out.
Complexity of Options Instruments
Options are complex financial instruments that require a deep understanding of option Greeks and strategies. Many traders, especially those new to the market, do not invest the necessary time and effort to fully grasp these concepts, which can lead to poor decision-making.
Huge Risks with Naked Option Selling
Naked option selling, where a trader writes options without owning the underlying asset, exposes one to significant risk. A large move in the opposite direction can lead to substantial losses, quickly wiping out the trader's capital.
Lower Returns Compared to Other Strategies
Despite the potential for higher returns in some scenarios, option writing often yields lower returns compared to more active trading strategies such as intraday trading or option buying. While some traders benefit from the short-term gains, others find that the consistent returns from other strategies more appealing.
The Prevalence of Institutions and Traders
Institutions, High Net Worth Individuals (HNIs), and Big Traders dominate the option selling world due to their sufficient funding and trained personnel. These entities are more equipped to handle the risks associated with options trading. They also see a satisfactory return on capital through the use of options, making the effort and capital investment worthwhile.
For these reasons, many of the most successful traders and firms have honed their strategies around option writing, while others opt for different trading methods that better suit their risk tolerance and investment goals.
For those interested in learning more about options trading, you can follow my blog Delhi Day Trader or visit me on Twitter at @DiscplinedTrder. Continuous learning and practice are key to mastering the nuances of options trading.
A Fallacy in the Statistic
It's essential to clarify that the statistic often mentioned—75% of all options held to expiration expire worthless—is based on the CME's analysis of open interest on the expiration date. This statistic doesn't fully capture the complexity of options trading, as many option buyers do not hold their options until expiration.
When an option is out of the money (OTM), it becomes worthless, but an in-the-money (ITM) option can still yield profits. For instance, if a trader sells an option for $8 and it expires ITM for $10, they have still made a profit of $2 per option. However, the statistic is not robust, as it does not account for the dynamic nature of options and the potential for short-term gains.
As a disclaimer, the information provided is for educational purposes only. Options trading carries significant risks, and it is crucial to consult with a financial planner to ensure that the strategy aligns with your risk tolerance and investment goals.