LIQUIDITY

Though the price of the underlying stock, the time left in

the life of an option, and the volatility of the underlying stock can

be factors that constitute 90% of the price of the stock option,

another factor that has a powerful indirect influence on option

price behavior is the amount of liquidity that exists in a specific

listed option. Liquidity refers to trading volume, or the ability to

move in and out of an option position easily.

Liquidity requires that plenty of buyers and sellers be available

to ensure such transactions. Options that do not have liquidity

may trap you into a position or prevent you from taking a

large enough position to make the transaction worthwhile. Liquidity

in the options market can be measured by the number of

specific listed options that are traded every day and the open interest;

open interest means the number of contracts that have

not been closed out and are presently open.

For example, how many IBM Jul 60 calls are traded on the

average day? Calculating this average would give you an idea of

this option’s liquidity. Note that liquidity changes throughout

the life of a specific option. The IBM Jul 60 call may have no liquidity

at all when the stock is at 90 because the option is so far

in-the-money that no one is interested in that option. On the

other hand, it may not have any liquidity at all if the stock is at

30 because now the option is so far out-of-the-money that it

hardly has any value at all.

Also, if there are eight months left in that IBM Jul 60 call, its

price may be so high that it will lack the necessary liquidity to be

an effective trading vehicle. In fact, options that usually have lives of seven, eight, or nine months normally do not have the

liquidity that an option of two or three months would maintain.

Option Writers

If you are buying the right to sell or buy stock at a certain

price over a given time, you have to be buying that right from

someone. That someone is the option writer. In other words, if

option buying is analogous to a side bet on the price action of a

specific stock, the backer of that side bet is the option writer, the

casino owner.

He takes the bets of the option buyer and, in a sense, pays off

when the option buyer is a winner. When the option buyer is the

loser, he pockets the option proceeds, what the buyer paid for the

option.

Put simply, option writers sell an option rather than buy it.

The option seller ( writer) has a time advantage over the option

buyer because unlike the buyer, time works for the seller. As time

passes, the value of the option depreciates. This depreciation, this

value, slips into the pocket of the option writer.

Let’s take an example. Let’s say that you purchase a call option—

an Intel October 25 call. Let’s say that there are three

months left in the life of that option, and you pay a price of $300,

plus commissions. At the same time that you are buying that option,

someone unknown to you, on the other side of the Options

Exchange is selling (writing) that option and is receiving your

$300.

This money will go into his account, so, in a sense, you have

just put $300 into the pocket of the option writer. Now he has certain obligations. If you request 100 shares of Intel by exercising

your option, he must deliver to you 100 shares of Intel stock

at a price of 25.

Let’s assume that the Intel price is now at 23, which means

we are working with an out-of-the-money option. One month

passes, and the stock has moved from 23 to 24. The Intel Oct 25

has depreciated in value from $300 to $200, even though the

stock has moved upward.

The option writer now has a paper profit of $100, less commissions.

If he wishes, he can go back into the Options Exchange,

buy that option back for $200, take his profits and, in a

sense, close the casino door.

On the other hand, if he thinks that Intel is going to stay

where it is or not move any further than 26 or 27 on the upside,

he can hang onto that option and wait for it to continue to depreciate

to zero. If you, the option buyer, hold onto the option,

you will continue to see it depreciate in value, unless the stock

moves up suddenly in a strong and positive direction.

In other words, the option writer has an advantage. While he

is backing your bet, or option, it is depreciating. You, the option

buyer, while holding that bet are losing money. However, if you

prefer, you can be the option writer rather than the buyer.

That’s right. You, too, can be an option writer. You can take

the role of the casino or bookie. Where else can you do this legally?

TWO TYPES OF OPTION WRITERS

The covered option writer and the uncovered (naked) writer

are the two types of option writers.

The covered option writer sells an option on 100 shares of

stock that he has bought (owns). He benefits from selling the option,

having the time value of the option on his side and, at the

same time, profits from the upward move of the stock, offsetting

any possible losses from the option he has just written. This kind

of strategy is very conservative and the most popular today.

The uncovered (naked) writer, on the other hand, is very

speculative and writes (sells) the option on 100 shares of stock

that he does not own. There is unlimited risk to the naked call

writer (betting the stock won’t go up) and extensive risk to the

naked put writer (betting the stock won’t go down).

To guarantee to both the options buyer and to the Options

Exchange that the naked writer will make good on the options

that he writes, he must put up cash and/or collateral to back up

his naked option writing position.

THE HOW-TO TO OPTION WRITING

The only difference between buying and writing options lies

in the order in which you carry out the process. The option

writer sells an option to open a position and buys an option to

close that position. This process releases him from the responsibilities

that are part of his option obligations. Conversely, the option

buyer buys an option to open a position and sells an option

to close the position, an act that relinquishes the rights that he

purchased with that option.

The option writer, like the option buyer in the options market,

has the advantage of liquidity. At one moment, he can write an option,

and at the next moment, he can close out that position on the

Exchange by buying back the option. In this way, the shrewd option

writer can avoid being assigned (exercised) by the option buyer

or exposing himself to the potential dangers of option writing.

Though the price of the underlying stock, the time left in

the life of an option, and the volatility of the underlying stock can

be factors that constitute 90% of the price of the stock option,

another factor that has a powerful indirect influence on option

price behavior is the amount of liquidity that exists in a specific

listed option. Liquidity refers to trading volume, or the ability to

move in and out of an option position easily.

Liquidity requires that plenty of buyers and sellers be available

to ensure such transactions. Options that do not have liquidity

may trap you into a position or prevent you from taking a

large enough position to make the transaction worthwhile. Liquidity

in the options market can be measured by the number of

specific listed options that are traded every day and the open interest;

open interest means the number of contracts that have

not been closed out and are presently open.

For example, how many IBM Jul 60 calls are traded on the

average day? Calculating this average would give you an idea of

this option’s liquidity. Note that liquidity changes throughout

the life of a specific option. The IBM Jul 60 call may have no liquidity

at all when the stock is at 90 because the option is so far

in-the-money that no one is interested in that option. On the

other hand, it may not have any liquidity at all if the stock is at

30 because now the option is so far out-of-the-money that it

hardly has any value at all.

Also, if there are eight months left in that IBM Jul 60 call, its

price may be so high that it will lack the necessary liquidity to be

an effective trading vehicle. In fact, options that usually have lives of seven, eight, or nine months normally do not have the

liquidity that an option of two or three months would maintain.

Option Writers

If you are buying the right to sell or buy stock at a certain

price over a given time, you have to be buying that right from

someone. That someone is the option writer. In other words, if

option buying is analogous to a side bet on the price action of a

specific stock, the backer of that side bet is the option writer, the

casino owner.

He takes the bets of the option buyer and, in a sense, pays off

when the option buyer is a winner. When the option buyer is the

loser, he pockets the option proceeds, what the buyer paid for the

option.

Put simply, option writers sell an option rather than buy it.

The option seller ( writer) has a time advantage over the option

buyer because unlike the buyer, time works for the seller. As time

passes, the value of the option depreciates. This depreciation, this

value, slips into the pocket of the option writer.

Let’s take an example. Let’s say that you purchase a call option—

an Intel October 25 call. Let’s say that there are three

months left in the life of that option, and you pay a price of $300,

plus commissions. At the same time that you are buying that option,

someone unknown to you, on the other side of the Options

Exchange is selling (writing) that option and is receiving your

$300.

This money will go into his account, so, in a sense, you have

just put $300 into the pocket of the option writer. Now he has certain obligations. If you request 100 shares of Intel by exercising

your option, he must deliver to you 100 shares of Intel stock

at a price of 25.

Let’s assume that the Intel price is now at 23, which means

we are working with an out-of-the-money option. One month

passes, and the stock has moved from 23 to 24. The Intel Oct 25

has depreciated in value from $300 to $200, even though the

stock has moved upward.

The option writer now has a paper profit of $100, less commissions.

If he wishes, he can go back into the Options Exchange,

buy that option back for $200, take his profits and, in a

sense, close the casino door.

On the other hand, if he thinks that Intel is going to stay

where it is or not move any further than 26 or 27 on the upside,

he can hang onto that option and wait for it to continue to depreciate

to zero. If you, the option buyer, hold onto the option,

you will continue to see it depreciate in value, unless the stock

moves up suddenly in a strong and positive direction.

In other words, the option writer has an advantage. While he

is backing your bet, or option, it is depreciating. You, the option

buyer, while holding that bet are losing money. However, if you

prefer, you can be the option writer rather than the buyer.

That’s right. You, too, can be an option writer. You can take

the role of the casino or bookie. Where else can you do this legally?

TWO TYPES OF OPTION WRITERS

The covered option writer and the uncovered (naked) writer

are the two types of option writers.

The covered option writer sells an option on 100 shares of

stock that he has bought (owns). He benefits from selling the option,

having the time value of the option on his side and, at the

same time, profits from the upward move of the stock, offsetting

any possible losses from the option he has just written. This kind

of strategy is very conservative and the most popular today.

The uncovered (naked) writer, on the other hand, is very

speculative and writes (sells) the option on 100 shares of stock

that he does not own. There is unlimited risk to the naked call

writer (betting the stock won’t go up) and extensive risk to the

naked put writer (betting the stock won’t go down).

To guarantee to both the options buyer and to the Options

Exchange that the naked writer will make good on the options

that he writes, he must put up cash and/or collateral to back up

his naked option writing position.

THE HOW-TO TO OPTION WRITING

The only difference between buying and writing options lies

in the order in which you carry out the process. The option

writer sells an option to open a position and buys an option to

close that position. This process releases him from the responsibilities

that are part of his option obligations. Conversely, the option

buyer buys an option to open a position and sells an option

to close the position, an act that relinquishes the rights that he

purchased with that option.

The option writer, like the option buyer in the options market,

has the advantage of liquidity. At one moment, he can write an option,

and at the next moment, he can close out that position on the

Exchange by buying back the option. In this way, the shrewd option

writer can avoid being assigned (exercised) by the option buyer

or exposing himself to the potential dangers of option writing.