The Role of the Options Buyer and Seller
The person, who sells option contract to the option buyer as his opening trade, is also known as option writer, seller or granter. Opposite trade to the option buyer is taken by the option writer. Because of this, he or she has the counter risk profile of the option buyer. The option writer has a temporary liability. If he or she is being called to fulfill his or her obligation, he or she just likes the insurance underwriter. However, the option writer is paid by the option buyer a premium upfront for taking on that risk, which he or she will keep it. If the option buyer doesn’t exercise his or her option, the option contract will be left to expire worthless. In this case, the option writer will earn the premium that the option buyer pays to him or her early. It is much the same way an insurance underwriter does.
Market movements will cause the option prices react differently. How it will react is totally dependant on whether the options are call or put options. If the market price increases, it gives a positive effect on call options but a negative effect on put options. In the other way round, if the market price decreases, it gives a negative effect on call options but a positive effect on put options.
If you estimate that the underlying market will make a concrete move higher, you can buy a contract of call option and after the market has gone up, sell it to earn a profit. Reversely, if you estimate that the underlying market will make a concrete move lower; you should buy put option and after the market has gone down, sell the put option to earn a profit. Based on the above statements, if the market price is going up, the call option prices will go up too. However, the put option prices will go down if the market price is going up.
Let’s try an example of buying a contract of call option on CAT shares and deeply discuss each component. Let’s us make an assumption in this example that CAT shares are trading at $30 in the 5th of February. So, we will buy 1 CAT March 29 call option. The ask price of the option in that moment is $3.4. The premium that we need to pay is equal to the option ask price times 100, which is equal to $340. This amount is not yet deduced by any transaction commission. In this example, buy 1 means buying one contract of CAT call option. One contract of CAT call option will give us the right to buy 100 units of CAT share. One contract is like one agreement that involved 100 units share. CAT is the underlying security on which the option is based. March is the month in which the option expires and it is on the third week Friday in that month. 29 is the exercise price, which is also known as strike price. By owning the call option at this strike price, we have the right to buy 100 units of CAT share at $29 at or before expiry in March.
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