What are the risks of writing options on stocks and indices?

Writing of options is the same as selling an option. Every option has a seller and a buyer. For example when X buys a 320 call option on SBI at Rs.5 his view is that the price of SBI will go above Rs.325 so that he can make a profit after covering the cost of the option. On the downside his maximum loss is restricted to Rs.5. The seller (writer) of the option has a maximum income of Rs.5 but his losses can be unlimited. The option seller will have a view that SBI does not go above 320 so that the entire premium can become his income. That is how option buyers and option writers come together and create the market.

But do you know the risks of writing options? Writing options in Indian market, as in other markets, entails unlimited risk if the price movement is against you. This applies irrespective of whether you are writing options on stock or on indices. The two big disadvantages of options are the risk of negative price movement and the risk of margins. Let us understand these risks in greater detail..

You are exposed to price movements against you
Let us go back to the case of SBI. You can sold an SBI 320 call option at Rs.5. Your risk starts above Rs.325. On the downside, even if the stop price falls to Rs.250, your total income as an option write will be limited to Rs.5 only. However, if the price of SBI moves above Rs.325, your losses can be unlimited. At Rs.350, your total loss will be Rs.25 and it continues limitlessly. That is why normally when you write options you have to take care of one of the things. Firstly, you have to write options with stop losses. Alternatively, you have to ensure that your short option is part of a hedged position so that you are not exposed to one-side risk.

Volatility could actually work against you
When you buy options, volatility works in your favour. However, when you sell options the volatility of the stock works against you! Let us understand this point in greater detail. Let us go back to the Rs.320 call option on SBI which you written at Rs.5. Let us say that the price of SBI has gone up to Rs.340. Theoretically, your loss should be Rs.15 after considering the Rs.5 you received on the option. But then options trade at a price which is (intrinsic value + time value). So when SBI touches Rs.340, the 320 call option will not trade at Rs.20 but at a higher level of say Rs.25. Therefore your notional loss will be Rs.20 and not Rs.15. This becomes critical when you have to report your MTM on a daily basis.

Higher initial Margin risk
When you buy options, you pay premium margins. That is because your maximum loss on the trade is limited to the premium paid. But when you sell options your losses are unlimited just like a long or short futures position. Hence your initial margining will be exactly like in case of futures when you write options. You will be charged the (SPAN margin + exposure margin) as part of your initial margin when you sell options. You need to factor in the financial cost of margins when you write options and ensure that your option premium earning covers that cost.

The risk of mark to market margins
The other margin that you need to pay apart from initial margins is the MTM margins when the price movement goes against during the month. Normally, when your total margin including MTM goes below the maintenance margin, the broker will make a margin call on you. This is again a risk you need to be prepared for if you sell options.

There used to be an assignment risk, which no longer exists
In the past, stock options in India used to be American options and index options were European options. American options could be exercised at any time before expiry and hence when an option was exercised, it had to be assigned at random to a writer of the option. That was another risk for the option write. However, stocks have also shifted to European style options and hence that risk is not there any longer.