What is an 'Option'

An option is a financial derivative that represents a contract sold by one party (the option
writer) to another party (the option holder). The contract offers the buyer the right, but not the
obligation, to buy (call) or sell (put) a security or other financial asset at an agreed-upon price
(the strike price) during a certain period of time or on a specific date (exercise date).
BREAKING DOWN 'Option'
Options are extremely versatile securities. Traders use options to speculate, which is a
relatively risky practice, while hedgers use options to reduce the risk of holding an asset. In
terms of speculation, option buyers and writers have conflicting views regarding the outlook
on the performance of an underlying security.
Call Option
Call options give the option to buy at certain price, so the buyer would want the stock to go
up. Conversely, the option writer needs to provide the underlying shares in the event that the
stock's market price exceeds the strike due to the contractual obligation. An option writer
who sells a call option believes that the underlying stock's price will drop relative to the
option's strike price during the life of the option, as that is how he will reap maximum profit.
This is exactly the opposite outlook of the option buyer. The buyer believes that the
underlying stock will rise; if this happens, the buyer will be able to acquire the stock for a
lower price and then sell it for a profit. However, if the underlying stock does not close above
the strike price on the expiration date, the option buyer would lose the premium paid for the
call option.
Put Option
Put options give the option to sell at a certain price, so the buyer would want the stock to go
down. The opposite is true for put option writers. For example, a put option buyer is bearish
on the underlying stock and believes its market price will fall below the specified strike price
on or before a specified date. On the other hand, an option writer who shorts a put option
believes the underlying stock's price will increase about a specified price on or before the
expiration date.
If the underlying stock's price closes above the specified strike price on the expiration date,
the put option writer's maximum profit is achieved. Conversely, a put option holder would
only benefit from a fall in the underlying stock's price below the strike price. If the
underlying stock's price falls below the strike price, the put option writer is obligated to
purchase shares of the underlying stock at the strike price.
Option Writer
A writer is the seller of an option who opens a position to collect a premium payment from
the buyer. Writers can sell call or put options that are covered or uncovered. An uncovered
position is also referred to as a naked option. For example, the owner of 100 shares of stock
can sell a call option on those shares to collect a premium from the buyer of the option; the
position is covered because the writer owns the stock that underlies the option and has agreed
to sell those shares at the strike price of the contract.
BREAKING DOWN 'Writer'
An option is uncovered when the writer does not have an offsetting position in the account.
For example, the writer of a put option, who agrees to buy shares at the contract’s strike
price, is uncovered if there is not a corresponding short position to offset the risk of buying
shares.
The primary objective for option writers is to generate income by collecting premiums when
contracts are sold to open a position. The largest gains occur when contracts that have been
sold expire out of the money. For call writers, options expire out of the money when the share
price closes below the strike price of the contract. Out-of- the-money puts expire when the
price of the underlying shares closes above the strike price. In both situations, the writer
keeps the entire premium received for the sale of the contracts.
Covered writing is considered to be a conservative strategy for generating income.
Uncovered or naked option writing is highly speculative due to potential for unlimited losses.
Call Writing
Covered call writing generally results in one of three outcomes. When the options expire
worthless, the writer keeps the entire premium and can write options again to generate
income. If the options expire in the money, the writer can either let the underlying shares be
called away at the strike price or buy the option to close the position.
The outcomes of writing uncovered calls are generally the same with one key difference. If
the share price closes in the money, the writer must either buy stock on the open market to
deliver shares to the option buyer or close the position. The loss is determined by the cost of
buying stock over the strike price or closing the option position, minus the premium received
when the position was opened.
Put Writing
When a put writer is short the underlying stock, the position is covered if there is a
corresponding number of shares sold short in the account. In the event the short option closes
in the money, the short position offsets the loss of buying the shares. In an uncovered
position, the writer must either buy shares at the strike price or buy the position to close. The
loss is the difference between the market value of the shares and the strike price or the cost of
closing the position, minus the initial premium.
Process of underwriting an option
Writing an option refers to the opening an option position with the sale of a contract or
contracts to an option buyer. When writing a call option, the seller agrees to deliver the
specified amount of underlying shares to a buyer at the strike price in the contract, while the
seller of a put option agrees to buy the underlying shares. A covered call is written when the
underlying shares are held in the seller’s account, while puts are considered to be covered if
the seller has sufficient cash in the account to purchase the required amount of shares.
BREAKING DOWN 'Writing An Option'
Put and call options generally cover 100 shares, have a strike price at which shares may be
transacted and have an expiration date. Investors can write option contracts to generate
portfolio income and, under certain circumstances, be used as an alternative to placing limit
orders to buy and sell stocks. When options are written, the money paid for the contract is
referred to as a premium.
In the agreement between parties, call option buyers have the right but not the obligation to
buy the underlying shares at the strike price prior to the expiration of the contract. With put
contracts, buyers have the right but are not obligated to sell shares at the strike price. Option
sellers, on the other hand, are required to execute transactions as per contract specifications.
In The Money Options
In the money means that a call option's strike price is below the market price of the
underlying asset or that the strike price of a put option is above the market price of the
underlying asset. Being in the money does not mean you will profit, it just means the option
is worth exercising. This is because the option costs money to buy.
BREAKING DOWN 'In The Money'
In the money means that your stock option is worth money and you can turn around and sell
or exercise it. For example, if John buys a call option on ABC stock with a strike price of
$12, and the price of the stock is sitting at $15, the option is considered to be in the money.
This is because the option gives John the right to buy the stock for $12 but he could
immediately sell the stock for $15, a gain of $3. If John paid $3.50 for the call, then he
wouldn't actually profit from the total trade, but it is still considered in the money.