A Dashing Blade said:
Tell you what Bulldozer/CYOF/Struchio . . . why don't
you start the debate off by telling us
what your choice is and why.
No?
Thought not.
Actually, I'll answer it for you.
Your answer is the "finite gain but unlimited loss" choice. Correct?
Now, this answer relies on the fact that European style options cannot be exercised early.
Thus, in the event that a written put/call goes from being out-of-the-money to become in-the-money, it will always be able to be rolled back into a longer dated strike.
As a deep itm put's total premium contains little actual time value (perhaps 5 or 10 points?) and given that (say) somewhere in the high tens of time value was originally taken in (70-80?), the ability to always roll back effectively only defers the crystallisation of the original written premium.
It may take three or four rolls back for the (final) written put to expire worthless, but this should happen eventually given that stock markets in developed countries rise over the long term.
Thus the only way a writer of european options will blow him/herslf out of the water when they cannot maintain the margin requirement
So far, so good, we're still in "Writing Options 101" territory.
Let's get back to that margin requirement.
In London, brokers (and locals) use what are known as "Clearing Firms". These are companies that, among other things, do all the intermediate paperwork between the broker executing a trade on behalf of the client and the counterparty to the trade, and ensures that the brokers aggregate margin is maintained (ie the clearers "client" is the broker not the broker's client) to the exchange.
Now, in the small print of all three counterparty agreements (Exchange/Clearer, Clearer/Broker and Broker/Client) will be a clause stating that margin requiremnts can be changed at any time.
In reality, this means that, when the market experiences a sudden, sharp, usually overnight gap, margin requirements can rise and indeed the methodology of working out margin requirements can change.
Remember the bit about clearers only being concerned about a brokers aggregate margin requirement?
What this means is that should a broker be unable to maintain it's overall margin (which has to be in place by close of business that day remember) the clearer has the right to close out any and all option positions to bring the margin in line. The same goes for the Broker/Client arrangement and, I believe, the same goes for the Exchange/Clearer relationship.
As an example, say the market tanks out, and the margin on a clients written put position balloons from (say) £20,000 to (say) £750,000. Legally, the broker has to have cleared funds in it's account with the clearer. I don't care how big the client is, not many private clients (if any) are that liquid. Would you, as the broker, be comfortable funding this position relying on the clients word that the money will be there eventually? Will your view change if market craps out the next day and the margin balloons even more?
So, bearing in mind that unfunded margin actually means that it's funded by the next entity up the food chain with that entity having the legal power to close positions, you should be able to see why the theory is not confirmed by the practise.
E&OE, pretty sure I've got all the realationships described accurately but happy to be corrected
