klin
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An option contract is very much like an insurance contract. When you buy an option contract, you pay premium to the writer. If there's nothing happen till the expiry date, the option writer pocket the money as profit. If something does happen, say you call MSFT at $30, and it does run to $40 before expiry date, then the writer has to deliver 100 shares MSFT per contract to you at $30 - he will suffer the $10 difference minus premium you paid as loss, just like car insurer has to pay if there's an accident or make moeny if no accident for the year.
That's why writting naked option is so risky, you are actually an insurer of prices of stocks/indices. You can make money when the prices neither move nor move against you, even it's moving against you, you can still make money if it doesn't move too fast or too far. You have much better chance to win, but your loss could be substantial.
Most insurance companies will by insurance from reinsurers to lower the risk. You, as an option writer has to hedge your positions as well to protect yourself from being wiped out when the price moves sharply against you. The the cost of hedge is the expense of your profit from premium. In a nutshell, you are paid to monitor the price of the equity and take appropriate actions whenever necessary.
That's why writting naked option is so risky, you are actually an insurer of prices of stocks/indices. You can make money when the prices neither move nor move against you, even it's moving against you, you can still make money if it doesn't move too fast or too far. You have much better chance to win, but your loss could be substantial.
Most insurance companies will by insurance from reinsurers to lower the risk. You, as an option writer has to hedge your positions as well to protect yourself from being wiped out when the price moves sharply against you. The the cost of hedge is the expense of your profit from premium. In a nutshell, you are paid to monitor the price of the equity and take appropriate actions whenever necessary.
