Buying options compared with writing options — two different games

The answer

Buying an option and writing an option are not 2 sides of the same trade in any way that matters to you. A buyer pays a premium, can lose all of it, and can lose it often. A writer receives a premium, can gain only that premium, and can lose many multiples of it. The buyer usually loses a little. The writer usually wins a little. The writer's rare loss is the one that ends accounts.

Why this costs you money

This is the article in this cluster that has the highest chance of preventing a serious financial loss, so it is worth being blunt.

Writing options feels safe, and the feeling is produced by real evidence. If you write out-of-the-money options every week, you will win most weeks. Not occasionally — most. A strategy that wins 8 or 9 times out of 10 produces a steady stream of small credits, a rising equity curve, and a growing belief that you have found something.

You have not found something. You have found the shape of the distribution.

Here is the arithmetic that people meet too late. Suppose you write options and collect a premium that is a small percentage of the margin required, and you win 9 times out of 10. Nine wins of 1 unit each gives you 9 units. The tenth event is not a loss of 1 unit. It is a loss of 15, or 30, or in a genuine gap, more than your account. You do not need bad luck for this. You need one ordinary market event, and ordinary market events arrive on a schedule nobody publishes.

The specific mechanism is the gap. A written option's risk is not the price moving; it is the price moving while you cannot act. Indian equity markets close overnight and reopen with a gap. American index futures trade nearly all night, but a stock can still open far from where it closed. A stop-loss order does not protect a short option position through a gap, because there is no trading between the 2 prices.

Now the second half, which is the buyer's side, and it is a different failure.

A bought option is a wasting asset. Its time value falls every day and reaches zero at expiry. That is not a risk; it is a certainty written into the contract. A buyer of short-dated out-of-the-money options is therefore paying a daily fee for the right to be correct within a deadline. Most days, nothing happens, and the fee is charged anyway.

SEBI's studies of individual traders in India's equity derivatives segment have repeatedly found that the large majority lose money. Both failures are in that number. The buyers bled out slowly. The writers were fine until they were not.

How it works

Four positions exist. Most explanations describe 2 and leave the reader to guess the rest.

Read the fourth column and then the fifth column together. That pairing is the entire subject.

A written call has no upper bound on its loss. If you write a call with a strike of 1,000 and the underlying goes to 4,000, you must deliver at 1,000 something worth 4,000. There is no price at which the loss stops. In practice brokers will close the position, but they close it at the market price at that moment, which is exactly the price that is hurting you.

A written put has a bound, and the bound is not comforting. If you write a put with a strike of 1,000 and the underlying falls to zero, you lose 1,000 per share, less the premium. That is not unlimited. It is simply large enough that the distinction stops being useful.

Covered and uncovered

A covered call means you already own the underlying shares and you write a call against them. If the option is exercised, you deliver shares you have. Your loss is not unlimited, because the shares rise with the option. What you give up is the gain above the strike. This is a real strategy with a real trade-off and it has its own article in this cluster.

A cash-secured put means you set aside the full cash needed to buy the shares if the put is exercised. Your worst case is that you buy shares you were willing to buy anyway, at a price you chose, having been paid a premium for the offer.

Naked writing, also called uncovered writing, means neither of those. You have posted margin, not the underlying and not the cash. The margin is a deposit against a possible loss. It is not a limit on the loss. If the loss exceeds the margin, you owe the difference.

This is the single most important sentence in the article, so it is worth reading again in its plain form. When you write an option without cover, your account balance is not your maximum loss.

Margin, and why it moves against you

A writer must post margin, and margin is not fixed.

In India the requirement is calculated as SPAN margin, from an exchange risk model, plus an exposure margin on top. When volatility rises, the model demands more. So on the day the market gaps against your short option, 2 things happen at once: your position loses money, and the margin required to hold it increases. The broker asks for cash at the moment you are least able to provide it.

That combination — loss plus a rising demand — is what turns a bad day into a closed account. It is not a rare mechanism. It is how essentially every option-writing failure in the case list below actually ended.

Why anyone writes at all

The honest answer, because you should know what the other side believes.

Over long periods, options have on average been priced slightly above what the subsequent realised movement justified. That difference is called the volatility risk premium, and it is the reason systematic option writing has a positive expected return over long periods.

The premium is real. It is also, precisely, payment for accepting the tail risk that everybody else wants to avoid. Insurance companies earn a premium for the same reason. The difference between an insurance company and an individual writing options is not the strategy. It is capital, diversification across thousands of independent risks, actuarial reserves, and a regulator forcing them to hold all 3.

An individual writing index options has none of those. They have one risk, taken repeatedly, funded by an account that must survive the worst single day.

What it tells you, and what it does not

A high win rate tells you almost nothing about a strategy. It tells you where in the distribution the strategy sits, not whether it makes money.

A strategy winning 90% of the time with an average win of 1 and an average loss of 12 has an expectancy of (0.9 × 1) − (0.1 × 12) = −0.3 per trade. It loses money, and the equity curve will rise steadily for months before it does. That is not a hypothetical shape. It is the standard shape of option writing without tail protection.

What the premium does tell you is the market's price for that specific risk. A strike that pays an unusually large premium is not generous. It is a strike the market considers genuinely reachable, and it is expensive for exactly that reason.

What none of this tells you is which side is right. Buying and writing are not good and bad. Buying is a poor default and writing is a dangerous default. Both are appropriate in narrow, defined circumstances.

The decision rule

Never write an option until you have written down, in currency, the loss from a 10% overnight gap against your position. Compare it to your total account value, not to the premium and not to the margin.

Then apply 3 gates. Any one of them failing means no position.

1. Cover. Is this covered by shares you hold, or by cash set aside for the

full obligation? If neither, you are naked, whatever your platform calls it.

1. The gap test. Does a 10% adverse gap leave you solvent, and able to hold

or exit at your choosing rather than the broker's?

1. The ratio. How many months of premium does 1 bad day cost? If the answer

is more than about 12, the strategy needs a full year without a single bad day to repay one bad day.

And for buying: never buy an option without writing down the required percentage move and the number of days available. If you cannot say what the underlying must do and by when, you have not made a decision.

Try this now

Ten minutes, split into 2 parts. The first part is for anybody. The second part is only if you have ever written an option, and it is the more important one.

Part 1 — the return that looks too good.

1. Open the option chain for the nearest expiry on the main index in your market.
2. Pick a call strike comfortably above the current level — one that seems very unlikely to be reached. Note the premium.
3. Multiply the premium by the lot size. That is the cash you would receive for writing 1 lot.
4. Now open your broker's margin calculator and find the margin required to write that 1 lot.
5. Divide the premium received by the margin required. Multiply by 100. That is your return on margin for this period.
6. Annualise it. If the expiry is 7 days away, multiply by 52. If it is a month away, multiply by 12.

What you should see. An annualised percentage that is far above any interest rate available anywhere. Frequently something in the tens of percent, sometimes much more.

Now ask the question that the number is designed to make you skip. Somebody is willingly paying that. They are not confused. They are buying protection or a position, from a market with millions of participants, at a price that clears. The premium is high because the risk is real, and the risk is entirely yours.

Part 2 — the gap test.

1. Take that same written call. Write down the strike.
2. Assume the underlying opens tomorrow 10% higher than it closed today. Compute that price.
3. Compute the intrinsic value at that price: opening price minus strike, never below zero.
4. Multiply by the lot size. That is your loss at the open, before any further movement.
5. Divide by the premium you received. That is how many months, or weeks, of premium the single gap costs.
6. Divide by your total account value, including everything.

What you should see. For most out-of-the-money strikes, a 10% gap produces a loss that is many times the premium received, and a significant fraction of a typical retail account. Some readers will find the number exceeds their account entirely.

A 10% overnight gap is not an extreme assumption. The Indian market fell sharply on 4 June 2024 on election results, and both markets moved violently in March 2020.

If the answer to step 6 is above 30%, you do not have an income strategy. You have a position that can end your participation in markets, and it will feel completely fine right up until the morning it does not.

Three real cases

1. Long-Term Capital Management, September 1998 — professionals, correct models, wrong tail The fund wrote large quantities of long-dated equity index options, to the point that market participants referred to it as a central supplier of volatility. The positions reflected a well-founded view that implied volatility was above realised volatility — the volatility risk premium described above. In August 1998 Russia defaulted, volatility rose sharply everywhere, and the positions lost money faster than the fund could fund them. A group of banks recapitalised the fund in an arrangement organised by the Federal Reserve Bank of New York on 23 September 1998. Two Nobel laureates in economics were partners. Being right about the average and wrong about the tail is not a small error in option writing. It is the only error that matters.

2. China Aviation Oil (Singapore), November 2004 — a hedger that became a writer The company, which supplied jet fuel, moved from hedging its physical exposure to writing large quantities of oil options. As oil prices rose through 2004, the short option positions lost money. Rather than close them, the company increased the positions in an attempt to recover. Losses of approximately $550 million were disclosed in late November 2004, the company sought court protection, and its chief executive Chen Jiulin was later convicted and imprisoned. The pattern is the one to remember: the position that begins as a hedge and continues as a source of income has changed into something else, and nobody announces the change.

3. OptionSellers.com, November 2018 — retail clients, debit balances A Florida-based firm managed accounts for individual investors using a strategy of writing uncovered options, primarily on commodity futures. In November 2018 natural gas prices rose very sharply within days while crude oil fell. The short option positions produced losses that exceeded many clients' entire account balances, leaving them owing money to the clearing broker. The firm's principal recorded a video message to clients acknowledging the losses, and the firm subsequently ceased operating. These were not leveraged speculators. Many were retired investors who had been told the strategy produced consistent income. It did produce consistent income, for years, and then it produced a debt.

The question that resolves it

A novice asks: how often does this win?

An expert asks: what does the single worst outcome cost, and can I survive it without changing anything else about my life?

Win rate is the first number an option-writing strategy will show you, because it is the flattering one. The distribution of losses is the number it will not show you, because you have to construct it yourself. That construction takes 5 minutes and it is the whole of the risk management.

What would make this wrong

If option writing were simply a bad strategy, then no professional would run it, and pension funds would not systematically sell index volatility. They do, and some have done so profitably for decades.

Here is what genuinely limits this article.

Covered writing is a different risk from naked writing. A covered call on shares you own has a defined worst case: you sell your shares at the strike and miss the gain above it. That is an opportunity cost, not a solvency event. Everything harsh in this article is about uncovered positions.

Defined-risk structures exist. Writing an option and simultaneously buying a further option at a more distant strike caps the loss. The maximum loss becomes the difference between the strikes, less the net premium. This is genuinely bounded, and it is the correct way for an individual to express a premium-collecting view. It also collects less premium, which is why it is less popular.

The volatility risk premium is real. The criticism here is not that writers are wrong on average. It is that being right on average is compatible with being insolvent, and an individual account has no mechanism for surviving the gap between the 2.

"Unlimited loss" is technically imprecise for puts. A written put's loss is bounded by the strike price, since the underlying cannot go below zero. This is true and it changes nothing practical. A written put on an index at a strike far below the market can still lose more in one day than a year of premiums.

Carry this

• A buyer's maximum loss is the premium, and losing all of it is the normal outcome, not the rare one.
• A writer's maximum gain is the premium, and the loss has no useful limit.
• Margin is a deposit against loss. It is not the size of the loss.
• Covered and cash-secured writing have a defined worst case. Naked writing does not.
• Before writing anything, compute the loss on a 10% overnight gap. If it exceeds 30% of your account, do not take the position.

Knowledge check

Related

• What an options contract is: calls and puts
• The covered call: getting paid to hold a stock you already own
• Theta: why every option you own is quietly losing value
• Risk management and position sizing
• ← Options and derivatives