For every option that is sold, someone must be liable if the option is exercised.
If I hold a call option entitlying me to buy a stock some time in the future, who do I buy this stock from ?
The writer of the option is the person who is obligated to deliver the underlying asset, if the option is a call.
The write of an option is the person who promises to buy the asset If the option is a put.
In reallife most simple option contracts are handled through an exchange so that the purchaser of an option does not know who the writer is.
The holder of the option can even sell the option to someone else via the exchange to close his position.
The purchaser of the option hands over a premium in return for special rights and an uncertain outcome.
The writer receievs a guranteed payment up front but then has obligations in the future.
Writing options is very risky.
The downside of buying an option is just the initial premium, the upside may be unlimited.
The upside of writing an option is limied but the downside could be huge.
For this reason to cover the risk of default in the event of an unfavourable outcome, the clearing house that registers and settles the options insists on the deposit of a margin by the writers of options.
Highly leveraged contracts are very risky for the writers of options
The buyer is risking a small amount; although he is very likely to lose, his downside it limited to his initial premium
The writer is risking a large loss in order to make a probablt small profit.
The writer is lekely to think twice about such a deal unless he can offset his risk by buying other contracts.
Gearing explains one of the reasons for buying options
If you have a strong view about the direction of the market then you can exploi derivatives to make a better return that just buying and selling the underlying.
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