What is an Option?
An option is simply a right that one has, i.e. the “right” to exercise or not to exercise the option.
What “Rights” Do My Options Give Me?
When you have a “Right”, you have something of value, since you have the right to make the decision as to your financial self-interest. In other words, the decision whether or not to exercise your option. You will exercise that “Right” when doing so makes you financially better off, or will not exercise the “Right” when doing so makes you financially better off.
Where Do I Get This “Right”?
Rights are not bestowed upon or given to you. You have to buy them.
Neither are Options “Issued”
Bonds, which represent debt, are issued by governments, organizations and companies.
These two fundamental financial securities are said to be in positive net supply, since the amount in existence is simply the quantity issued by the entity (so can never be negative).
Then, from whom do you buy these options?
Options are “Created”
Most financial derivatives including options (as well as futures and swaps) are not issued by any specific entity. Instead they are created when a willing buyer and a willing seller, called “counter parties”, come together and transact with each other. That willingness to come together to buy and sell creates the derivative (out of thin air). These financial derivatives are thus in zero net supply, since none exist until created by the two “counter parties”.
From Whom Do I Buy Options?
So, from whom do you buy these options? You buy them from a seller. The seller may own the option they sell, but need not. Indeed, since they are in zero net supply, the first two “counter parties” to transact must include a seller that does not own it.
Later transactions may include either sellers who do not own the option or sellers disposing of a previously purchased option. In fact, in addition to the exercise or expiry, the most common way, of getting out of your option position is to execute a closing or reversing trade, i.e. the counter party who previously bought now sells, or the counter party who previously sold, now buys.
So What About the Seller?
If the person who buys an option has purchased a right, then the person who sells it (also called the writer) has incurred an obligation. That person has an obligation to do as the buyer wishes should the buyer exercise. The person who previously bought the option and currently owns it is said to be long the option, while the person who previously sold the option and has the obligation is said to be short the option.
What Is the Cost of the Option?
There are two important points to note here.
- First, since the long purchases the option from the short, the option has a price, often called a premium. Since the most common way to get out of your option position is to execute a reversing trade, the profit or loss on the round-trip play comes from the difference in the premium from the opening trade to the closing trade.
Who Makes Money?
- Second, the fact that options are in zero net supply also means that they exhibit zero net profit. This means that, ignoring transaction costs (brokerage fees, taxes, etc.), every penny the long makes the short loses, and vice versa.
Since the long bought the option first, they makes money if the option increases in value.
Conversely, since the short sold the option first, they make money if the option decreases in value.
To see the background to Options Domination and have a better understanding of trading with Options, read our tutorial series: