Option Seller

Option Seller - Lake Batur, Bali, Indonesia
Option Seller

An option seller, also known as an option writer, gives the option buyer the right either to buy (call) or to sell (put) the asset at the exercise price. This gives the option seller some potential future liabilities against which he/she receives some cash up front equivalent to the price of the option. The option seller’s profit or loss is the reverse of that of the purchaser of the option.

More precisely, at expiration of the contract, the payoff of the call seller is π − max(0, ST − K) and the payoff of the put seller is π − max(0, K − ST), where π stands for the premium, ST is the asset T price at expiration, and K the strike price. K If the stock price increases, the call writer faces potentially unlimited losses. the same applies to the put writer, whenever the stock price falls.

While it might seem at first glance that the position of the option seller is very disadvantageous, market practice seems to indicate that most of the time it is profitable to write options on the market. This is particularly the case for out-of-the-money options that are the most heavily traded, meaning that option buyers pay too expensive insurance premiums against catastrophic events.

Broadly speaking, the profitability of option writing corresponds to the positiveness (on average) of the difference between implied volatility—which is paid by the option buyer—and realized volatility— which is paid by the option seller.

There have been several academic studies on the profitability of this trade. For instance, Bondarenko (2003) estimates that systematically writing at-the-money 1-month maturity puts on the S&P would have led to an average excess return of 39% per year from August 1987 to December 2000, with huge Sharpe ratios; although one should take care that the Sharpe ratio might not be a sensible measure due to the huge tail risk (extreme losses) involved in writing puts.

Option Seller
Option Seller

Writing calls on the market appears less risky and some authors have identified that it can also be profitable, notably when combined with a long position in the asset or when realized on single stocks rather than on the index.

Inspired by these results, the CBOE has recently launched two indices, which track the value of systematic option writing on the S&P 500 index. The BXM index is applying a buywrite strategy, also known as a covered call, which implies buying the underlying and simultaneously shorting at-the-money 1-month maturity calls.

the backtesting shows that over the period 1988–2006, the strategy would have posted the same performance as a simple long position in the S&P but with a volatility reduced by a third. CBOE has extended the strategy to other moneyness and to other indices (Nasdaq, Dow Jones Industrial Average, Russell).

The Put Write Index is designed to reproduce the payoff of a sequence of sales of 1-month, at-the-money, S&P 500 index puts while cash is invested at 1- and 3-month Treasury bill rates. Historical backtesting shows that the strategy would have outperformed simple long positions in the S&P 500 index by 50 basis points per year while the volatility of the strategy is only 60% of the index’s one. Investable versions of these indexes have been made available by investment banks or asset managers.