When you write a call option, you undertake a contract to sell to the option holder, if he requests, a house at the exercise price.
As the writer of the option, you are exposed to an unlimited risk, as we will see below.
Assuming that on date A:
The market price of houses is $102K.
You write a Call option “June 100 C H” for a premium of $5K (internal value 2, time value 3).
We will consider the loss to the option writer and the loss or profit on the transaction in three scenarios relating to the price of houses on Date B.
Scenario 1 – House prices in the market rise to $110K.
In this scenario, the option holder will want to exercise it. You – as the option writer – will be forced to buy a house in the market for $110K and sell it to the option holder for $100K (the exercise price).
In this case you will lose $10K on writing the option, and $5K on the transaction as a whole.
Diagram 13 shows the situation
As the price of houses increases, your loss from writing the option and from the transaction increases.
Scenario 2 – Market price of houses is $103K
In this scenario, you lose $3k on the option, but profit $2K as a whole on the transaction.
Diagram 14 shows the situation
Scenario 3 – House prices go down to $90K
In this scenario, the holder of the option will not want to exercise it, since he can purchase the house for just $90K.
You will be left with the profit from the premium of $5K.
Writing a Call option – General characteristics
- The basic use is when we expect a downward trend in the price of the underlying asset.
- We expect to profit on the transaction from the premium we receive.