Obligations when selling options – Option Trading FAQ

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Obligations when selling options

Q: I recently bought a call option. Since then, the stock price has risen and so has the call option. I wish to sell my call option for a profit but am I obligated to deliver the underlying stock if the option buyer decides to exercise his call option?

A: The short answer is “No”. You might have heard that options sellers have obligation to deliver the underlying stock. That is true only when you sell the call option as an opening transaction – also known as a sell-to-open transaction. In your case, it is a sell-to-close transaction, meaning you are selling the option to close out your open long call position and will no longer be a party in any contract and hence you are not obliged to deliver any stock.

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Selling options

Selling (or ‘writing’) options follows a similar process to buying options. You place orders to write options through your broker, and transactions are handled through the ASX Trade and Clear platforms.
Option writers must fulfil different requirements to holders throughout the life of the option, particularly the obligation to pay margins.

Choosing a broker

Options are traded through ASX-accredited brokers. You will need to sign a Client Agreement form before you start trading. If your current broker is not active in options, or accredited to advise on options, it is wise to seek out a specialist broker in this area.

Opening a position

You place an order to write options with your broker. You sell options to other investors or to market makers. Writing an option is called ‘opening a position’.

You will need to tell your broker whether you want to write a call option or a put option. Writing a call option obliges you to sell the underlying securities if the option is exercised, whereas writing a put option obliges you to buy the underlying securities on exercise. You will also need to tell your broker whether you wish to make a market order or a limit order.

  • A market order instructs your broker to sell at the best possible price.
  • A limit order instructs your broker to sell only at a specified price or better.

The buyer will pay you a premium for the option you write, the price of which is calculated by ASX.

You can sell options over securities that you do not own. This is known as a ‘naked’ transaction. However, this is a higher risk transaction than selling options in securities that you own (known as a ‘covered’ transaction). ‘Naked’ calls in particular can be risky; if the call is exercised you must be able to provide the securities. You should consult your financial adviser or broker before attempting ‘naked’ transactions.

Maintaining margins

As the option writer, you may also be liable for daily margin payments throughout the life of the option. ASX requires your broker to provide enough cash or collateral (such as shares or bank guarantees) to cover your (and others’ where applicable) obligations if the option is exercised. This is known as a margin. As option values increase and decrease, the margin required will also rise and fall. Brokers may also impose their own margin requirements over and above those required by ASX. Your broker, not ASX, will inform you of your margin requirements on a regular basis.

Your broker will also advise you if you need to increase your margin. You must usually do this within 24 hours, otherwise your broker may close out your positions, leaving you liable for any resulting losses.

Closing a position

You can close your positions at any time. This does not affect the other party, as your rights and obligations are simply transferred to another investor or market maker.

To close your position, you typically take an offsetting position. For example, if you had written a call option you would buy an equivalent call option (with the same exercise price and expiry date) to close out the position. You can make a profit on closing out if the premium you pay when you buy is lower than the premium you received when you opened your position – and vice versa.

Call Options: Right to Buy vs. Obligation

An option is a financial instrument whose value is derived from an underlying asset. Purchasers of call options gain the right to buy the underlying asset, or stock, at a predetermined strike price on or by a predetermined expiration date.

The market price of the call option is called the premium. It is the price paid for the rights provided by the call option. If at expiration, the underlying asset is below the strike price, the call buyer loses the premium paid.

Do Investors Have the Right to Buy Call Options or an Obligation?

The buyer of an option is not obligated to buy the stock at the strike price. They just have a right to do so, if chosen.

For example, let’s say that an investor buys one XYZ call option with a strike price of $10, expiring next week for a dollar. If the stock trades at $10.05 the day after the call option is bought, the investor has the right to buy the stock for $10 but is not forced to buy the stock.

What About the Writer of the Call Option?

On the other hand, a writer, or seller, of a call option is obligated to sell the underlying asset at a predetermined price, known as the strike price, if the call option that the investor sold is exercised. The writer of a call option is paid to take on the risk that is associated with being obligated to deliver shares.

For example, an investor sells a call option with a strike price of $15, expiring next week, for a dollar, and the stock is currently trading for $13. In this scenario, the writer collects a premium of $100 because an equity option contains 100 options per contract.

This indicates that the investor is bearish on the stock and thinks the price of the stock will decrease. The investor hopes that the call will expire worthless.

However, the day before the option expires, let’s say that the company publishes news that it’s going to acquire another company, and the stock price increases to $20. As a result, many holders of the call options exercise their options to buy. This means that the seller of the call option is obligated to deliver 100 shares of the company’s stock at $15 per share.

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