Writing a call option over shares can be a handy way to generate extra income. Though, as we discussed in last week’s article, it comes with a tradeoff.
By writing, that is selling a call option, you receive a premium — money that is paid into your account the following day. However, this premium comes with an obligation.
That is, that you must hand over the shares at the option’s strike price if the buyer exercises their option. You might already know this strategy as a ‘covered call’.
In return for receiving a premium, you are giving up a potential profit if the shares rally higher than the strike price. Therein lies the tradeoff.
It’s important when you write a call option that you own the underlying shares. That way, you have them on hand to deliver if the buyer exercises their call option.
What you don’t want to do is write (sell) call options without owning the underlying shares. That is, an ‘uncovered’ or ‘naked’ call. While it might generate some handy income, it could lead to massive losses if the share price jumps higher.
You could end up scrambling to buy shares as they rally higher, only to have to deliver them at a lower price. That is, the option strike price.
The role of the market maker
If you’ve traded options before, have you ever wondered who is on the other side of the trade?
While it might be another private trader, more than likely it is a market maker. As the name implies, their job is to make a market — that is, a bid and offer — so that traders can readily enter and exit the market.
If it is too risky, though, for a private trader to write call options without owning the underlying shares, what then for a market maker?
If a big option buyer comes into the market, the market maker is supposed to make them a market. That is, they must be prepared to take the other side of the trade. After all, it is something the ASX stipulates they must do.
With options traded on around 60–70 shares, it isn’t possible for the market maker to own shares in all of them to hand over if exercised. Especially if a trader buys a large number of options.
If the market makers take the other side of the trade, they could be exposing themselves to potentially unlimited losses. So how do they go about it?
Always another way
One of the beauty of options is their flexibility. You can apply numerous different strategies to almost any market conditions.
Some strategies aim purely to profit from a price move in the underlying shares. Others look to capture volatility spikes, or take advantage of time decay.
One of the great things about options is that they provide more than one way to implement a strategy. In option jargon, it’s called a ‘synthetic’ strategy.
Let’s go back to our market maker.
If someone wants to buy a swag of call options, the market makers job is to take the other side of the trade. That is, to write (sell) the call options to the buyer.
But as we have discussed, this could lead to potentially unlimited losses. A positive trading update, or takeover offer, could send the share price soaring.
So what is the market maker to do?
The answer has to do with this concept of synthetics. Buying a call option gives you exposure to an upwards move in the stock. That is equivalent to buying shares.
However, it’s not exactly the same risk exposure. Because you don’t own the underlying shares when you buy a call option, you are not exposed to a fall in the share price.
To compensate for this, you need to add another leg. To do that, you need to buy a put option to protect you from a fall in the share price.
In other words, the synthetic equivalent of buying a call option is to buy the underlying shares…plus buy a put option. So to hedge a written call position, this is exactly what the market maker does.
Once they write the call option, they buy the underlying shares. That way, they have them on hand to deliver them if the price rallies and the buyer exercises their option.
That leads to the second part of their hedging strategy. To protect themselves from a fall in the share price they also buy a put option. A put option enables them to offload the shares at the strike price if the share price sinks.
Either way, the market maker is covered. If the share price rallies, they have bought the stock and can hand it over if exercised.
And if the share price falls, the put option protects them on the downside. Either way, they keep the premium generated from writing the call option.
By using synthetic strategies, it enables market makers to do their job. That is simply, to make a market for traders. By doing that, it brings more traders into the market…and provides greater liquidity.
All the best,
Editor, Options Trader