Obligations of an Option Seller
Understanding Assignment Risk
Option sellers collect a cash premium. That's the primary reason that investors sell an option. When that option expires worthless, the cash premium represents the option seller's profit, but selling options does involve the risk of losing money. Pretty simple stuff.
A hedge is a trade that offsets, or partially offsets, the risk of owning another position. Hedging is is a bit more complex than simply buying or selling an option. For example, when you buy one call option (hoping for the stock to rally), you can sell a different option, collect some cash for that sale, and reduce the amount of money at risk.
Why would anyone hedge a position? For a very good reason: just in case your expectations do not occur. In other words, it reduces your loss when your prediction does not come true. Unless you are some sort of market wizard, you can expect that a significant portion of your predictions to fail. But there is a caveat for traders: It is important to practice careful risk management.
The hedging concept is easy to understand once you learn to understand how options work. This video) about options for beginners will help you understand the basic concepts of option trading.
Options do not always expire worthless, and it is essential that every option trader understands what happens when the option does not expire worthless (in other words the option is in the money at the time that expiration arrives.) Whenever you sell (write) an option that you do not already own, you become legally obligated to honor the terms of the option contract sold.
What are those obligations?
The call seller agrees to sell 100 shares of the underlying stock to the call owner. The trade occurs at the option strike price. This obligation remains in effect until the option expires.
The put seller agrees to buy 100 shares of the underlying stock from the put owner. The trade occurs at the option strike price. This obligation remains in effect until the option expires.
What triggers the obligations?
The obligations are only theoretical until something happens that triggers the process. Call owners have the right to force the option seller to honor his/her obligations by exercising their rights. As soon as the call owner instructs his/her broker to exercise an option, the option seller's obligations are triggered. Note that the option seller cannot force the option owner to exercise. That decision rests entirely with the option owner who bought the option, and paid cash to own the right to exercise. I hope that this makes sense because no one would buy an option, paying cash, unless there were some benefits to be derived from ownership.
Who enforces those obligations?
The option owner never has to be concerned with whether the option seller has the wherewithal to honor the option contract.
The OCC (Options Clearing Corporation) handles the exercise and assignment process, and when an exercise occurs, the option owner is guaranteed to get what he/she wants (i.e., to transform the option contract into a long or short position in the underlying stock).
What can you do to eliminate the obligations?
There are only two ways that the obligations of an option seller can be canceled:
- The option expires worthless. In other words, expiration day has come and gone and the option owner failed to exercise his/her rights.
- You can buy the same option that you sold. This is known as a closing transaction. Once you are no longer short the option, you can no longer be a notice that the option owner wants to exercise. That obligation has been transferred from you to the person from whom you bought the option. NOTE: In reality, there is no direct link between the buyer and seller, other than the transfer of cash when the option is traded. When an exercise occurs, the person who is selected to honor the options contract is chosen at random.
Understanding your obligations prevents unpleasant surprises.