Once you learn a little bit about writing a call and the potential risks involved, many options beginners wonder why you would ever want to write an options contract in the first place. The following is a simple example of writing a covered call and it helps explain by example why you might want to try it out

In this example, let’s assume that I’ve done some research on company ABC which is currently trading at $20 per share. My research tells me that the stock is trending a bit upward, but will probably go sideways for a while before making significant gains. So, I buy 100 shares (since one options contract represents 100 shares.) The fact that I now own the stock before I write the options contract means that this is a covered call (I own the stock and am writing against the stock I own).

Since I think the stock might hit $21.50 before expiration, I write a call contract with a strike price of $22 and set a contract price of $0.75 per share ( that’s 0.75 * 100 = $75). I’m hoping another investor will think that the price is going to go above $22 and buy my contract. Let’s say just such an investor exists and buys my contract.

Heres’ the math so far:

I bought $2000 worth of stock ($20 market price times 100 shares)
I collect $75 from the purchaser as my premium.
So I still own the 100 shares of stock, plus I now have an extra $75 in cash.

Now let’s fast forward to the the expiration date. If the stock price stayed under my strike price ($22), the contract expires and I keep the stock and $75.

However, if the stock went up to $23, the option purchaser will exercise their right to buy the stock from me at $22. In this scenario, I still win. Here’s how:
My outlays were the original $2000 I paid for the stock
I collected $75 on the option contract and was forced to sell my 100 shares for $2200.

So my profit was $2275 – $2000 = $275 (before tax and fees).

Now let’s say the stock went down to $18. I’m stuck with the stock, but I still have the $75 call contract premium which ends up offsetting my loss by $75. So if I decide to get out right now, my loss is only $125 instead of $200. So by writing the covered call, you are limiting your upside but cushioning the downside.

Some of the bigger fund managers use covered calls to free up cash. Using this technique they can lock in a purchase price for $1 a share and use their cash elsewhere. This is what is often referred to as a leveraged position.

For Further Reading:
How to Become a Pro at Trading Stock Options

You will sometimes hear about exotic options. What are exotic options? What’s the difference between a regular option and an exotic option? This brief primer is design to explain the basic differences and outline the most common exotic options.

Now, before you read this, you should have a fairly good understanding of regular options. If not, go back and read up on our tutorials covering option basics.

Exotic options and regular options share the concept of having the right to buy or sell an asset in the future, but the way investors realize profits using exotic options can differ dramatically from regular options.

The simple definition of an exotic option is that it is any type of option other than the standard calls and puts found on major exchanges. With regular options, an investor who buys a call option has purchased an industry-standardized right to purchase a specific amount of an underlying asset at the agreed upon strike price. An investor who buys a put option buys the right to sell the specific asset at the strike if the price of the underlying decreases. These regular options are also also known as plain vanilla options.

Exotic options, while retaining much of the basic structure of a plain-vanilla option, can have all kinds of different rules attached to them which can significantly change the nature of the option. It’s probably easiest to look at some examples of some of the most common exotic options:

Asian option: Anyone who invests in regular options will attest to their volatility. Asian options are a good way to reduce this volatility. These exotic options have a payoff that depends on the average price of the underlying asset over a certain period of time as opposed to at maturity. The Asian option is sometimes called an “average option.”

Barrier option: This type of exotic option has a payoff that depends on whether or not the underlying asset has reached or exceeded a predetermined price. The right to purchase the underlying at an agreed strike price only becomes valid when the price hits the agreed upon ‘barrier.’ This is unlike a regular option because the holder of a regular option can buy the underlying security at the strike price at any time after inception.

Chooser option: The chooser option gives the investor the right to choose whether the option is a put or a call at a certain point during the option’s life. Unlike plain-vanilla options that are always purchased as a call or a put at inception, a chooser exotic option can essentially change type during the life of the option.

The final difference between exotic options and regular options is how they trade. Regular options trade with calls and puts and can be found on major exchanges such as the Chicago Board Options Exchange. Exotic options are mainly traded over the counter (OTC), which means they are not listed on a formal exchange, and the terms of the options are generally negotiated by brokers or dealers and are not as standardized as they are with regular options.

For this reason, exotic options are best left to advanced options traders. If you want to get into the game, you’ll most likely have to do it through an options broker.

The two types of options are calls and puts.

A call option gives the holder the right to buy an asset at a certain price within a specific period of time. Calls are similar to having a long position on a stock. Buyers of call options are expecting that the stock price will increase substantially before the option expires.

A put option gives the holder the right to sell an asset at a certain price within a specific period of time. Puts are very similar to having a short position on a stock. Buyers of put options are expecting that the price of the stock will fall before the option expires.

Buyers and Sellers in the Options Market

There are four types of participants in options markets depending on the position they take:

1. Buyers of calls
2. Sellers of calls
3. Buyers of puts
4. Sellers of puts

If you buy an option you are called the holder of the option and if you sell an option you are called the option writer.

If you are the buyers are said to have a long position, and if you are the seller you are said to have a short position.

There are important distinctions between option buyers and option sellers which affect the risk associated with the option contract. Here is a summary of those distinctions.

• Call holders and put holders (buyers) are not obligated to buy or sell. They have the choice to exercise their rights or let the contract expire without exercising their right.
• Call writers and put writers (sellers), however, are obligated to buy or sell if the holder exercises their option. This means that a seller may be required to make good on a promise to buy or sell.

If this seems confusing at first, it becomes more clear as you get into some concrete examples, which we do on other articles here.

Also, you need to understand that an option buyer has a known and manageable risk (the cost of the option contract plus brokerage commission is the entire risk). The potential gain by an option buyer is theoretically unlimited, but will always have some discreet value when the option is exercised.

Consider this simplistic example: You buy a call option on stock XYZ. As the holder of the option, you have the right to  buy 100 shares of XYZ stock on or before a set future date at $10 a share. At the time you buy the option, the XYZ stock is trading at $7 a share, so the writer is betting that the stock won’t go up by $3+ dollars by expiration. But let’s say the stock goes bonkers and climbs to $100 a share by expiration. You exercise your right and get to buy 100 shares of XYZ from the writer for $10 a share.

Where does that stock come from?

Well, the writer either has the stock in his portfolio (he wrote a covered call) or he doesn’t (he wrote a naked call). Either way he loses. If he owns the stock, he’s obligated to sell the stock that is worth $100 a share to you for $10 a share – so he loses out. If he had bought the stock earlier at a sub $10 price, he didn’t lose money on the stock , but since he could have otherwise sold it for $100, he lost out on the ability to cash in on that profit.

On the other hand, if the writer wrote a naked call, he could be in some serious cash-flow problems. You see, he now has to go out and buy the shares at market price ($100 per share, or $10,000 for one contract) and then turn around and sell those shares to you for $10 per share. In this case the writer is out a very real $9,000. Ouch.

So the potential risk of an option writer much higher than an option buyer.

You may be asking yourself at this point, “So why would anyone ever want to write options if it is so risky?”  Well, if you know what you are doing, you can make a lot of money by pricing your contracts in such a way that you have the advantage. The key phrase is that you have to know what you are doing, and you need to know it really well.

For this reason, option writing is a much more advanced and strategic topic, and it’s best to wait until you are an advanced options trading before you begin trading options as a seller. So if you are a beginning options trader, stick with buying options until you have more experience.

In fact, some very successful options investors are content to use managed strategies that never delve into options writing. But if you get really good at trading options, you may want to try your hand at writing options at some point. At this point, it is good enough to just understand that there are always two sides of an options contract.