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Introduction to Options

This course is reproduced with the permission of XPRESSTRADE Back to Trading 101 Index

Selling Options

At this point, you might well ask, who sells the options that option buyers purchase? The answer is that options are sold by other market participants known as option "writers," or "grantors." For every option buyer there is an option seller. In other words, for every call buyer there is a call seller; for every put buyer, a put seller. The sole reason for writing options is to earn the premium paid by the option buyer. When an option is sold, the proceeds from the sale are credited immediately to the writer's account. If the option expires without being exercised (which is what the option writer hopes will happen), the writer retains the full amount of the premium.

If the option buyer exercises the option, however, the writer must pay the difference between the market value and the exercise price. It should be emphasized and clearly recognized that unlike an option buyer who has a limited risk (the loss of the option premium), the writer of an option has unlimited risk. This is because any gain realized by the option buyer -- if and when he exercises the option -- will become a loss for the option writer.

Reward

Risk

 Option Buyer

Except for the premium, an option buyer has the same profit potential as someone with an outright position in the underlying futures contract. Unlimited profit potential.

An option buyer's maximum loss is the premium paid for the option. There is pre-defined maximum risk for the option buyer.

 Option Writer

An option writer's maximum profit is the premium received for writing the option. For the option seller, profit potential is limited.

Except for the premium received, risk is the same as having an outright position in the underlying futures contract. Unlimited risk.

Options are considered "wasting assets." In other words, they have a limited life because each expires on a certain day, although it may be weeks, months, or even years away. The expiration date is the last day the option can be exercised; otherwise it expires worthless. The option writer hopes that the option he has sold expires worthless, in which case he keeps the premium received when the option was sold.

If a short option position is "covered," this means that the seller holds an offsetting position in the underlying commodity itself or a futures contract. For example, the seller of a Treasury Bond call option would be said to be "covered" if he was long the Treasury Bond futures contract. If the futures market were to rally, his long futures position would offset the losses on the short call position. Conversely, the seller of a Corn put would be considered "covered" if his account also contained a short Corn futures position. A decline in the futures market might cause a loss on the put position, but the short futures position would generate a gain. This is what's meant by a "covered" option sale.

If the option writer is not "covered," he would be said to have a "naked" position. In such instances, the seller of the option will likely be required to post margin. This is because, as we learned above, the option writer's potential risk is unlimited. Margin is therefore required, to protect the brokerage company that carries (and is responsible to the exchanges for) the writer's account. As the underlying futures market moves against the writer's option position -- in other words, the futures market rallies against a short call position, or the futures market declines against a short put position -- the option writer may be asked to deposit additional margin.

Next chapter: Option Terms

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