Could you please explain more about who these counterparties are exactly? Do they include brokerages?
I'm trying to understand why a counterparty would enter into an arrangement where a stock price change obligates them to financial liability like this. Presumably there's some upside if the stock price goes the other way, but it's unclear who the $ would come from in that case.
Also:
Who originates options? When someone buys an option, is it the brokerage who collects the fees? Is the counterparty already involved at that point?
Let's say I own a bunch of SPLK and want to make some passive income. I am the counterparty to the call purchaser in this example.
I can sell call options 10% out of the money each week and make some nice cash. If my plan was to hold the stock long term, there's no downside risk because if the stock goes down, I get to keep the cash (premium) from selling the calls. If it goes sideways or slightly up I get to keep it as well.
The only "downside" is it goes up >10% in which case i've made that 10% + premium, but I've now had my stock taken away from me.
In this case, I lose out on an additional 10% in upside because it went up 20% overnight.
That still seems like a pretty good deal. You missed out on capturing the entire upside, but lost no real money.
Loss aversion and all that, but it feels like a reasonable strategy where you still come out ahead in the worst case. In the typical case, you can continue to collect those pennies.
> In the typical case, you can continue to collect those pennies.
Top notch comment, considering options trading is often described as "picking up pennies in front of a steamroller."
> Loss aversion and all that, but it feels like a reasonable strategy where you still come out ahead in the worst case
You don't come out ahead in the worst case – the option you wrote can settle deep ITM and you are compelled to sell a stock at a loss. Worst case you could lose a major chunk of change.
Suppose I buy 100 shares of $ABC for $10 (total cost for me is $1000) and then sell a call option for $1 with a strike price of (say) $50. The absolute worst case scenario is that the value of my *shares* goes to $0, in which case I've lost $999.
On the other hand, if the price shoots up to, say, $85, I'm still obligated to sell them at $50. Since I bought them at $10, I've still made $4001 profit, but I'm still dissatisfied because I would have made $7500 if I hadn't sold the call option.
What you're describing is what happens if I don't already own those shares and the price skyrockets. If the counterparty exercises their $50 option when the current price is $85, then yes, I'm obligated to buy the shares at market price and sell for a total loss of ($STRIKE_PRICE * 100) - $5000 - 1.
Clearly I am not an option trader, but so long as you own the option you are selling (covered) doesn’t that make your maximum loss the stock itself (+potential profit from the positive movement). I thought ruin can only happen if you are selling naked?
But you were offering it based on the market price when you offered it. The "loss" is merely one of opportunity, you're not actually losing any value you had when you sold the option, right?
Correct, but this sub-section of the thread veered off into the naked options territory and I was simply trying to clear up the confusion of the person I was replying to.
I'm trying to understand why a counterparty would enter into an arrangement where a stock price change obligates them to financial liability like this. Presumably there's some upside if the stock price goes the other way, but it's unclear who the $ would come from in that case.
Also: Who originates options? When someone buys an option, is it the brokerage who collects the fees? Is the counterparty already involved at that point?