Part Three: The Mechanics of Buying and Writing Options

Who Writes Options and Why

Up to now, this booklet has discussed only the buying of options. But it stands to reason that when someone buys an option, someone else sells it. In any given transaction, the seller may be someone who previously bought an option and is now liquidating it. Or the seller may be an individual who is participating in the type of investment activity known as option writing.

The attraction of option writing is some investors is the opportunity to receive the premium that the option buyers pays. An option buyer anticipates that a change in the option's underlying futures price at some point in time prior to expiration will make the option worthwhile to exercise. An option writer, on the other hand, anticipates that such a price change won't occur in which event the option will expire worthless and he will retain the entire amount of the option premium that was received for writing the option.

Example: At a time when the March US Treasury Bond futures price is 125-00, an investor expecting stable or lower futures prices (meaning stable or higher interest rates) earns a premium of $400 by writing a call option with a strike price of 120. If the futures price at expiration is below 129-00, the call will expire worthless and the option writer will retain the entire $400 premium. His profit will be that amount less the transaction costs.

While option writing can be profitable activity, it is also an extremely high risk activity. In fact, an option writer has an unlimited risk. Expect for the premium received for writing the option, the writer of an option stands to lose any amount the option is in-the-money at the time of expiration (unless he has liquidated his option position in the meantime by making an offsetting purchase).

In the previous example, an investor earned a premium of $400 by writing an US Treasury Bond call option with a strike price of 129. If, by expiration, the futures price has climbed above the option strike price by more than the $400 premium received, the investor will incur a loss. For instance, if the futures price at expiration has risen to 131-00, the loss will be $1,600. That's the $2,000 the option is in-the-money less then $400 premium received for writing the option.

As you can see from this example, option writing as well as option buyers need to calculate at break-even price. For the writer of the call, the break-even price is the option strike price plus the net-premium received after transaction costs. For the writer of the put, the breakeven price is the option strike price minus the premium received after transaction costs.

An option writer's potential profit is limited to the amount of the premium less transaction costs. The option writer's potential losses are unlimited. And an option writer may need to deposit funds necessary to cover losses as often as daily.

Risk Caution
option writing as an investment is absolutely inappropriate for anyone who does not fully understand the nature and extent of the risks involved and who cannot afford the possibility of a potentially unlimited loss. It is also possible in a market where prices are changing rapidly that an option writer may have no ability to control the extend of his losses. Option writers should be sure to read and thoroughly understand the Risk Disclosure Statement that is provided to them.

Source: National Futures Association; published here with permission. This publication, Buying Options on Futures Contracts: A Guide to Uses and Risks, is the property of the National Futures Association.