We have looked at the buying side of option contracts. Now let's look at the selling side. When an investor sells an option contract they are said to be "writing" an option to the option buyer. The writer receives a premium from the buyer in exchange for taking on the risk of writing the option.
In the following example, the investor is writing a call option.
When an investor writes a call option the risk graph looks like the picture below. The call writer receives a premium in exchange for selling a call buyer the right to take the underlying stock away from them. For example, if the investor owns 100 shares of a stock they may write a call option to a call buyer. The risk is that the call writer will have the stock called away from them if the call buyer decides to exercise the contract. However, if the option contract is not exercised the call writer keeps the premium at expiration. An investor is not required to own the underlying stock in order to write a call option (the broker will require margin though).
If you recall from lesson 1.1, the writer of a call option has the obligation to sell the underlying stock to the call buyer if the buyer decides to exercise their right any time before expiration.
Breakeven at expiration = Strike Price + Premium Received
An investor writes 1 December 25 call option for
$2.00.
Break even at expiration = 25 strike + $2.00 premium = $27
(if underlying stock price is less than break even at expiration,
the option contract would expire worthless and the seller would keep the
premium.)
Payoff at expiration = Premium Received
At expiration underlying stock price is $24.
Payoff at expiration = $2.00
(the most that the option writer can profit is the premium received
from selling the option contract. If underlying stock price is less than
break even price at expiration [$26.99 or less], it would not make
sense for the call buyer to exercise the contract because the underlying
stock could be purchased on the open market for less. Therefore, the
option writer keeps the premium and the contract expires worthless.)
In the next example, the investor is writing a put option.
When an investor writes a put option the risk graph looks like the picture below. The put writer receives a premium in exchange for selling a put buyer the right to assign the underlying stock to them. For example, an investor may write a put option to a put buyer. The risk is that the put writer may become obligated to purchase the underlying stock from the put buyer if the buyer decides to exercise the contract. However, if the option contract is not exercised the put writer keeps the premium at expiration. An investor is not required to own the underlying stock in order to write a put option (the broker will require margin though).
If you recall from lesson 1.1, the writer of a put option has the obligation to purchase the underlying stock from the put buyer if the buyer decides to exercise their right any time before expiration.
Breakeven at expiration = Strike Price - Premium Received
An investor writes 1 December 45 put option for
$4.00.
Break even at expiration = 45 strike - $4.00 premium = $41
(if underlying stock price is more than break even at expiration,
the option contract would expire worthless and the seller would keep the
premium.)
Payoff at expiration = Premium Received
At expiration underlying stock price is $49.
Payoff at expiration = $4.00
(the most that the option writer can profit is the premium received
from selling the option contract. If underlying stock price is more than
break even price at expiration [$41.01 or more], it would not make
sense for the put buyer to exercise the contract because the underlying
stock could be sold on the open market for more. Therefore, the option
writer keeps the premium and the contract expires worthless.)
The writing (selling) side of option contracts may seem confusing at first. The key is to remember that option buyers are purchasing the rights while option writers are selling the rights. The writer receives a premium in exchange for taking on that risk. As you progress through the lessons these factors will become clearer.
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