Good to be a writer?

Around 81% of all Nifty index options expire without getting exercised. Monthly data analysed for one-and-a-half years revealed that on the date of expiry, 81% of Nifty call and put options went out-of-the-money. Out-of-the-money refers to a situation when the Nifty spot prices are higher than the Nifty put (sell) options (or vice-versa for call options). In other words, they become worthless.

?Prior to 2008, when fewer strike prices (6-7) were available, these figures were comparatively less? says Bhavin Desai, manager?derivatives at Motilal Oswal Financial Services. Even on the Chicago Board Options Exchange (CBOE), the extent of options expiring without getting exercised is around 70%. Does that mean that the writer of the options is smarter than the buyer? Read further.

For starters, the writer of options are those who sell a put or a call (buy) option. And since an option gives its buyer the right but not an obligation to exercise the option, for the option buyer the maximum loss from a transaction is to the extent of the premium paid. And for a option writer, the maximum profit is to the extent of the option premium pocketed.

In contrast, when options are in-the-money, the extent of losses is unlimited for option writers. For example, assume one buys a Nifty call option (July’10 expiry) at a strike price of 5,500 by paying a premium of Rs 200. On the day of expiry (July 29) Nifty spot prices closed at 5,408. Here, the option becomes out-of-the-money as it is better for the call option buyer to buy Nifty from the cash market instead of exercising the option. So, he doesn’t exercise the option and loses the premium (Rs 200). The option writer in contrast pockets the same premium amount. But assume the Nifty had jumped to 5,800, then option buyer would exercise the option and profit (300-200). If Nifty hit even higher, option buyers gain even more at the expense of option writer.

In that sense, the option writer’s losses are unlimited since he has to fulfill the contract at all costs. As an investor, one might wonder, why would anyone take unlimited risk, for a gain which is only limited to the extent of the premium earned?

?Option premium at various strike prices differ based on the probability of Nifty touching those levels? says Savio Shetty, derivative analyst at Prabhudas Liladhar. So typically, an option writer would price the premium is such a way that it is costlier to buy at strike prices that are near to the spot prices. Often that’s the reason option buyers tend to buy options that are two to three stirke prices away from at-the-money strike prices. Because it’s cheaper. However, this is turn also reduces the probability of option writer making money. It’s occasionally, when the equity markets move drastically, say more than 8% of so, that the option writers are caught on the wrong foot.

Take for instance, in May ’09, when Nifty shot up 28%; only 31% of the call options were out-of-the-money on the day of expiry. Or take the case of October ’09, when market corrected 7.3%; in that month 74% of put options ended out-of-the-money on the day of expiry. In most other months, these figures were otherwise above 90%.

But such drastic movement in Nifty prices are rare despite a rise in volatility. In the last 19 months, for instance, only on two occasions the Nifty moved (up or down) by more than 10% in a month.

?Also, in a rising market (like it is now), it seems it is better to write a put option than a call option? says Siddharth Bhamre, head (equity derivatives) at Angel Broking. The FE study shows 73% of call options expired out-of-the-money while it was 90% for put options.

Having said, the argument that the writer of an option makes money 81% of the times is also faulty. First of all, one has to consider the fact that the ‘American’ options are being written in India. American options, as opposed to ‘European’ options, could be exercised by option buyer anytime before its expiry. So, in effect, the buyer of an option could exercise or reverse his position anytime before the last day of expiry.

While data for the Indian options market are not available, some reports quote an interesting fact for CBOE. That is, around 10% of options are exercised before expiry. Another 50-60% of option positions are closed prior to expiration and the remaining 30-40% are held till expiry. This is effect, means that it is likely that 10% of options become in-the-money during the option term and therefore get exercised.

Out of another 50-60% option contracts, it’s likely many are in-the-money, too. And the rest of the contracts (which is carried till expiry) are those mostly out-of-the-money or marginally in-the-money. This effectively, means only 21-28% of all options contracts expire out-of-the-money and remains unexercised and not 70% as it is believed to be.

The figure is likely to be similar for the Indian options market. This, in other words, means option writers aren’t as smart as they are believed to be. Also, it is also difficult to segregate players as option writers and buyers. This is because often in derivative strategies, a writer of an option is also a buyer of an option. In the end, what matters for an investor is choosing the right derivative strategy that suits the times of the market. Whether one is an option writer or buyer should be inconsequential.