In all of my prior articles on trading options, the examples have been based on buying an option, whether it is a call option or a put option. This is true for the purchase of either a call or a put.
How does the pool of contracts come into existence? Before the computer, the contract was written by hand. These opening transactions are done thousands of times a day. The mechanics of these transactions are handled by the option exchanges and the entire process is overseen by the Options Clearing Corporation.
In many cases, the options are written by options market professionals know as market makers. Writing options is part of the role of market makers at the option exchanges. These firms specialize in being the buyers and sellers of the options as the order flow dictates, and understand all facets of the options market.
This does not mean that the retail trader and investor can not be involved with writing options. There are some unique risks involved in writing options. The seller of an option takes on an obligation under the terms of the option contract.
In the case of writing a call option, the writer has the obligation to deliver the underlying stock to the buyer of the call option if the stock price is above the strike price at expiration For example, a decision is made to sell write a May Call option. This means that the option will expire on the 3rd Friday in May. But this is the process and should be understood by the seller to eliminate surprises.
It is the value that is against the seller of the option. For ever penny that IBM is above Theoretically IBM could keep rising in price to infinity, and expose the short option position to unlimited risk. The math would look like this. Obviously there are ways to help minimize the risk of being an option writer. It is not the purpose of this article to discuss how to minimize risk, but rather to show the concept of option writing and to point out the risk at the extremes.
In later articles, the concept of writing an option against existing stock positions to create income will be discussed. Also how writing options in conjunction with the purchase of other options to create more elaborate strategies with defined risk will be explored.
John Emery has been a professional trader for more than a decade, trading in stocks, options and stock indexes on a daily basis. A former proprietary trader, Emery has written numerous articles for TradingMarkets over the years on topics ranging from trading basics to his own trading methods and strategies.
Emery uses options both to trade and as a risk reduction tool. At Connors Research, we are using it as an overlay to many of our best strategies to make them even better -- now you can, too. The Connors Group, Inc.More...