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Option Buyer v/s Option Writer

Option Buyer v/s Option Writer
by Nilesh Jain 21/04/2017
New Page 1

An Option Buyer is someone who buys an option from sellers/ writer. The buyer of an option pays a premium and buys the right of that particular option but is not obliged to writer to exercise the option.

Buyer of an option has limited risk up to the premium paid, and theoretically it can earn unlimited reward if stock/index moves significantly higher (in case of call) and lower (in case of put). The biggest risk is of time decay and drop in volatility. If market remains range bound or near expiry, premium will erode faster due to time decay factor, which will result into negligible profit or may turn into losses.

Options should be bought only when you are confident that stock/index will move significantly either side because if stock/index remains range bound, the premium of both At-The-Money and Out-The-Money options will decrease and become zero till expiry. Advance traders can also buy options if they expect volatility to shoot up.

An Option Writer is someone who sells an option but without holding any long positions, it is like short selling the stock/index. The option writer receives premium and has the obligation to keep the agreement if buyer of an option exercises his rights. Writer of an option has a higher probability of making money compared to an option buyer. Option writers primarily trade on time decay and volatility, while market movement is secondary factor. Following are the two scenarios where option writers can initiate positions:

If he expects stock/index to trade sideways and volatility is expected to go down.

If he expects stock/index to move higher (if a put option) or lower (if a call option).

 

Option Buyer

Option Writer

Risk

Buyer of an option has limited risk (to the extent premium paid)

An Option writer has unlimited risk

Reward

Option buyer has unlimited profit potential

Option writer has limited profit potential (to the extent premium received)

Reward to risk ratio

Option buyer has high reward to risk ratio

Option writer has low reward to risk ratio

Probability

Probability for option buyer of making money will be 33%

Probability for option writer of making money will be 67%

Rights/obligation

Option buyer has right but not an obligation to exercise the option

Option writer has obligation but doesn’t have a right to exercise the option

Margin requirement

Option buyer pays premium to buy options

Option writer has to pay margin money, which will be same as futures (as risk is unlimited like futures).

Time Decay

Time decay works against an option buyer

Time decay works in favour of an option seller

Breakeven

Breakeven is the point where option buyer starts to make money.

It is the exact same point at which option writer starts to lose money.

Following is the payoff table of Option buyer (Long Put Strategy)

Current Nifty Price

Rs 8200

Strike price

Rs 8200

Buy Price

Rs 60

BEP (strike Price - Premium paid)

Rs 8140

Lot size (in units)

75

 

On Expiry Nifty Closes at

Net Payoff from Long put option

7800

340

7900

240

8000

140

8100

40

8140

0

8200

-60

8300

-60

8400

-60

Following is the payoff table of Option Writer (Short put strategy)

Current Nifty Price

Rs 8300

Strike price

Rs 8200

Selling Price

Rs 80

BEP (strike Price - Premium received)

Rs 8120

Lot size (in units)

75

 

On Expiry Nifty Closes at

Net Payoff from sell put option

7800

-320

7900

-220

8000

-120

8100

-20

8200

0

8300

80

8400

80

8500

80

Piece of Advice:

Investors, who have a low risk appetite, should stick to basic strategy like option buying, whereas option writing should only be used by sophisticated investors as risk involved in writing of an option is higher compare to reward.

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