Supply of Options (both Call and Put)
The supply of options comes from two sources:
- First-hand options: these are investors writing “new options”
- Second-hand options: these are investors who are holding options and are selling them.
The writing of options is the opposite of purchasing options.
Anyone may write an option (if he has sufficient sureties – since option writing, as we shall see, entails a high level of risk).
The stock market itself does not write options but acts as only an intermediary between the writer of the option and the purchaser.
In respect to the options they have written, the option writers are exposed to losses only, up until the expiry date!
Because of this risk, they demand compensation, which in their opinion is full compensation. The compensation is the price at which the option is written (sold).
They hope that the loss entailed in writing the option, if it occurs, will be less than the amount of money they collected in respect to the option (plus interest which they could have received on that amount of money up to the exercise date).
Let us assume, for example, that in return for a Call 100 option I wrote, I received $1,000.
If I wrote the option and on exercise date the DJ Index stood at 110, I would have lost $1,000.
However, it will be recalled that when I wrote the option, I received $1,000 for it, and thus in this example, I have lost nothing.
As the DJ Index goes up, so the loss on writing the Call option increases (for a more detailed example, see Strategy Number 2).
Note: The writer of the option has an obligation to exercise it.
The purchaser of the option (Call or Put) has the right to exercise the option. The purchaser pays the writer of the option in return for this right.
Payment arrangements between the writers of options and their purchasers
When an option of any kind is exercised, the writer of the option pays the stock exchange, and the stock exchange transfers the money to the purchaser of the option which has been exercised.
Brokers, banks and the stock exchange profit from the purchase commissions and from dealing with options.
Characteristics of option writers
When buying an option, the loss is limited to the cost of the option. On the other hand, when writing options, the loss is unlimited, and thus the writing of options is usually carried out by professional entities such as provident funds, mutual funds and portfolio managers. Of course, private investors can also write DJ Index options.