There are two sources which supply the market with options.
Source 1 – Second-hand options – received from investors who bought a particular option and decided to sell it. When investors sell an option second-hand, the number of options in the market does not change, only the ownership of the options changes.
Source 2 – First-hand options – These are issued by investors, known as “option writers”. An option writer in fact issues a liability instrument, on his own behalf.
When writing a Call option – the liability instrument is to sell the underlying asset at the exercise price.
When writing a Put option – the liability instrument is to purchase the underlying asset at the exercise price.
In return for liability which the option writer is taking on, he demands an appropriate premium. Anybody can write an option. There is no need for a permit or license. All you need to do is to call the bank or your broker and give him an order, which contains the following details:
- What type of option you want to write.
- Number of options.
- What premium you are requesting for them.
The order is sent immediately to the stock market for execution, and it “looks” for its buyer, in the same way as what happens when selling shares.
When investors write options, the number of options in the market increases.
Sureties – a pre-condition for writing options
As we will see further on, option writers are exposed to unlimited risks. The banks and the brokers are responsible to the buyer of the option to realize the obligation stated on the option. In view of this, they will not offer for sale the option you have written, if you do not provide them with sufficient sureties for executing your obligations. Usually the sureties required at stage A enable you to meet your obligations, even if the price of the underlying asset changes by 20% to your disadvantage. If the market price tends against you, the banks will quickly demand additional sureties from you. If you don’t have any, they will buy, at your expense, an option identical to the one you wrote, and as we will see, this action determines (more or less) the loss incurred.
When an investor writes a new option, we refer to this as “opening a position”. If the option writer buys in the market the same option he wrote. For example: He wrote and then bought “June 100 C H” options, this is regarded as him having cancelled the original option he bought, since the purchase of the option neutralizes the option that he wrote. From the options traded in the market, one option is removed despite the fact that in actuality the option he wrote and the option he bought continue being traded.