Naked Puts and Covered Calls

[ashu1234]

And finally like to add something to this thread, well nobody wants to keep open his positions as an option writer, and buyer of option can go for exercing options if there is significant difference between strike price and cmp(theoretically primium takes care of that).
And last derivatives are zero sum game, so one's gain is another ones loss, As rightly point out by Aw01 there was time in past month where there were no sellers, so writers couldn't square off their positions by buying back the option.

 

[ashu1234]

No Ashu,
Gsalvadi is right....

say, u r the second party in my hypothetical situation...
when CMP is 100, u buy Call 110 (assume @ Rs 5 premium) as u r bullish on the stock...
your analysis turns right and stock price reaches 110... (assuming premium now Rs 15)

Now, two options u have to close this position, but in both case, ur profit will be different:

1. you sell that option, and thus u earn premium difference of Rs 10 (15-5) per lot... thus Rs 10 is your gross profit (before brok, etc)

2. you choose to exercise this option.... as rightly mentioned by gsalvadi, "exercise" is done between close price & strike price.
If the close price of your stock is 110 & strike price is also 110, you would get NIL credit (110-110)
on this NIL credit, you have to reduce your premium initial paid (Rs 5).. thus, you have actually incurred a Gross Loss of Rs 5 (before brok etc)...

overall, it would be better to sell/square-off that option instead of exercising that option, for the option buyer



if suppose you "exercise" when Close is 115, then you would get credit of Rs 5 (115 close price minus 110 strike price)...
On this Rs 5 credit, you have to reduce the initial premium paid (Rs 5)...
here too, you are making NIL gross profit, if your choose to "exercise" your option

Opps my mistake!!!
Haven't noticed the word "exercised" and replied the post thinking in mind "squarring off" by premium differentials.
Mistake regretted.

 

[NOMINDTR]

@ AW10 & Sunil

I am afraid we not are clear with option's life span

1. An option is always exercised. If the buyer did not, then the option is automatically exercised by the exchange.

2. No option has a chance to be free from "exercising"

3. An option writer "creates" an option by writing it and he has the obligation till the expiry. The process is irreversible

4. An option writer can offset his obligation by buying options, we call this as covering an option. By doing so, the writer has an option that would safeguard him against the option he "created"

5. A buyer need not exercise an option he bought. He can simple sell it. It means he can hand over to option he bought to somebody else in the market

6. This exchange of options happens as the premium goes up. The buyer wants to book profit on premium by selling an option. No way it interrupts an option's exercise

7. Again, every option is exercised with no exemption, only on exercise, an option's life span completes

 

[NOMINDTR]

And finally like to add something to this thread, well nobody wants to keep open his positions as an option writer, and buyer of option can go for exercing options if there is significant difference between strike price and cmp(theoretically primium takes care of that).
And last derivatives are zero sum game, so one's gain is another ones loss, As rightly point out by Aw01 there was time in past month where there were no sellers, so writers couldn't square off their positions by buying back the option.

More than 90% of the options are written by Institutional players like MF, FIIs; the big hands.

Off course it is a zero sum game, still they write options only for hedging. Every option they write has a direct correlation with their equity holdings. So it is always difficult to correlate option pricing to the market level.

I have seen many a time when the market shoots up, Calls going up, Puts remain reluctant to go down with lower premium when compared to rate of change that takes place in Call's premium.

IMO, option spreads are least understood by retail players and they are real powers placed on a chess board.

If not so, just imagine why the exchange fixes strike prices, though a market participant write an option. He has only few choice of strikes.

And why a bull can not take long and a bear can not take short positions on a general Call as in futures market? Why there are two options, call and put options unlike futures market?

 

[NOMINDTR]

yup... i realised my mistake in wording my earlier question....,

i realised that i am mentioning "exercising" instead of square off.... i deleted that message, but u were quick to respond to it...

It happens to every one of us. we can not help it

 

[AW10]

Re: @ AW10 & Sunil

gsalvadi.
I have different view on option writing so sorry I disagree with your explantion at certain places.

1. An option is always exercised. If the buyer did not, then the option is automatically exercised by the exchange.

Only if it is ITM. OTM or ATM options are never execercised as their excercise does not make any sense.

2. No option has a chance to be free from "exercising"

True for ITM option. If buyer is not excercising his right, then at expiry, exchange will excercise the right. Exchange does nothing for OTM/ATM options and let them expire worthless.

3. An option writer "creates" an option by writing it and he has the obligation till the expiry. The process is irreversible

If option writer buys back /square-off his short position then he comes out of this obligation.
Lets extend this logic to ideal case - Assume there are only 2 writers (A and B) in the market and 1 buyer (X).

1) when A write the first option (Short Option), Open Interest count goes to 1. It has been bought by X.

2) When A square-off his position by buying it back, say he gets it from writer B. OI still remains at 1. X still has his LONG Option intact. Obligation of A is closed. Now B carries the obligation to delivere it to X, whenever excercised.

3) If X wants to Sell his LONG option position, but A is not buying it.So we need new buyer in the mkt say Y. At the end of this txn, A still has obligation for 1 option. OI is still 1 as 1 option is floating in the mkt. Now, Y holds the right. X is out the market.

4. An option writer can offset his obligation by buying options, we call this as covering an option. By doing so, the writer has an option that would safeguard him against the option he "created"

You are right. Buy this buy back process, writer closes his position and his txn is over.

7. Again, every option is exercised with no exemption, only on exercise, an option's life span completes

As explained above, as per understanding, options life, from writers perspective is over as soon as either it is excercised, or he squares-off the open position. Option still might be in mkt as there has been new writer. But from first writers perspective, position (and hence obligation) is closed.
I have never Read, experienced or heard that somebody getting assigned on the option that they sold and squared-off later.

btw, here is the text from CBOE site.

How do you nullify the obligations of a short call or put?
Any investor with an open short position in a call or put option may nullify the obligations inherent in that short (or written) contract by making an offsetting closing purchase transaction of a similar option (same series) in the marketplace. This transaction must be made before assignment is received, regardless of whether you have been notified by your brokerage firm to this effect or not.

Hope I have logically explained my understanding of this topic. If there is any gap, then please highlight it, either here or feel free to PM me.

Happy Trading.

 

[NOMINDTR]

Thanks AW and sorry that I have unknowingly assumed ITM options in my post

You are so right logically. I would like to know once again where the root of the issue lies IMO.

One can nullify obligation by buying same series option.

It means writer's(A) obligation is nullified as some other writer(B) obliged the same to writer (A)

I have a difference in understanding that A has two offsetting, nullifying open positions. Logically he has no obligation, two open positions which nullifies each other to zero, then only CBOT site could use the appropriate word nullifying.

IMO, nullifying entirely different from "covering" or having NIL open position.

The effect (obligation) is nullified by two offsetting positions.

Kindly let me know is my understanding right.

 

[AW10]

gsalvadi,
At most of the places we are on the same side except at 1 point, I think.

It means writer's(A) obligation is nullified as some other writer(B) obliged the same to writer (A)

At this point, as per my understanding, A is out of the market. He had -1 position which is converted to 0 after buyback. Now the right/obligation is between original option holder who bought from A and new writer B.
Exchanges record will have 0 position marked against A but will have -1 against B.

As per your understanding, even after buyback A is still known to the exchange as seller which I think, is not the case. Exchange forgets about A at this stage.

Anyway, this topic doesn't make any difference to the trading.

As long as reader of this thread don't get confused and just remember that -
1) option writer can buyback his option to manage his obligation
2) if not, then be prepared to assignment by exchange .
3) assignment by exchange can be triggered as a result of other buyer
excercising their right, or final settlement proceeding.

(plz add any other practical point that traders need to remember and I have missed in this summary)

Happy Trading.

 

[ashu1234]

gsalvadi,
At most of the places we are on the same side except at 1 point, I think.



At this point, as per my understanding, A is out of the market. He had -1 position which is converted to 0 after buyback. Now the right/obligation is between original option holder who bought from A and new writer B.
Exchanges record will have 0 position marked against A but will have -1 against B.

As per your understanding, even after buyback A is still known to the exchange as seller which I think, is not the case. Exchange forgets about A at this stage.

Anyway, this topic doesn't make any difference to the trading.

As long as reader of this thread don't get confused and just remember that -
1) option writer can buyback his option to manage his obligation
2) if not, then be prepared to assignment by exchange .
3) assignment by exchange can be triggered as a result of other buyer
excercising their right, or final settlement proceeding.

(plz add any other practical point that traders need to remember and I have missed in this summary)

Happy Trading.

A question here why you said A had -1, as per me exchange assigns +1/2 for each fresh position taken whether you are buying or selling(condition is it has to be fresh) and when he gets out of market he will be assigned -1/2.

 

[AW10]

Sorry, I wrote the reply without thinking about this interpretation.
What I meant was -1 = 1 contract SHORT, +1 = 1 contract Long and 0 = no position.
That's how I reflect in my trade journal so just followed that thought process in my post.
So, A has -1 position means, exchange knows that A is SHORT 1 contract (i.e. A has written one option).

Not sure about what you meant with +1/2 (I read it as +0.5) and -1/2. Can u explain it bit more or give the source of your information to help me understand it further ?