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Q & A. Who buys all those options?

I am an avid follower of your blog and thanks for such a great service you are providing to option newbies.

I have a question regarding covered calls. I hear that so many
folks (including
mutual funds etc) sell covered calls on the stock they own.

Who buys these calls? Is it the hedge funds?  But how do they make money
by doing this unless its a fast bull market? This question has me baffled.

Please enlighten us with this info on your blog?

Jack

***

Hi Jack (I hope no one greets you that way at the airport)

There are so many options trading these days (several billion contracts every year) that there is no single strategy that overwhelms the markets.  No matter how many people want to sell options – covered calls or any other – there are always buyers.

You are correct in that there are a bunch of funds that adopt covered call writing as a strategy, but compared with the total number of mutual funds there are on the market, very few are allowed to use options in any form.

The buyers

Professional market makers are either standing in the trading pits (where the options trade) on the exchange floors, or are represented by computers.  Those market makers continuously show a bid (price they are willing to pay when buying) and ask (price that want to receive when selling).  Thus, there is always a market for your orders (or any orders) that arrive on the trading floor.  These days, orders arrive electronically.

Many orders are filled instantly because the price that the buyer is willing to pay meets, or exceeds the price the seller is asking.  At other times, there is no trade and the seller's offer waits for someone to be willing to pay the price.  No seller is require to settle for the market maker's bid. You may ask any price you choose.  The higher that price, the greater the likelihood that no one will want to buy the calls you have for sale.

Your premise that those buyers want to see a big rally is not accurate.  You must remember that plenty of people sell put options, and the market makers will be overloaded with puts on occasion.  That means the buyers of options don't always want to see a big rally, sometimes they want to see a big decline (when they buy puts).

While it's true that an order to sell a very large number of contracts may go unfilled for awhile, unless the price is lowered, in general buyers and sellers find an agreeable price and the trade is made.

This is true for all options – puts and calls.

So, the question is: how do these buyers make any money.  That's a good question, and most rookies never give it a thought.

1) The option buyers hedge their trades.  They do not take the risk of hoping the market will move in the direction that makes their option portfolio profitable.

2) How do they hedge?  First, the term 'hedge' means: to reduce the risk of owning.  That is normally accomplished by taking on a new position that offsets, or at least partially offsets, the risk of owning the current position.

First they use the Greeks to quantify their risk.  If you are not familiar with 'the Greeks' take a bit of time to learn about them.  For now, let's just say that the Greeks allow the market maker (or anyone else) to evaluate the risk of a specific position with regards to:

  • How much will the trader earn or lose if the stock moves higher or lower (delta)?
  • How much does it cost to own the options (options are wasting assets and decline in value as time passes) (theta)?
  • If the market becomes more (or less) volatile, how much can I expect my option portfolio to gain or lose (vega)?
  • Plus other risk factors

The Greeks allow these market makers to see how much risk they have, and then the traders can decide how much risk to offset (usually the decision is to offset 100%).

They hedge by buying or selling other options and/or shares in the underlying stock.  The goal is to have no market risk.  Instead, they hope to profit by accumulating options at or near the bid price and selling at or near the ask price.  If all goes well and the hedge is truly market neutral, they can prosper.

Complete hedging is a complicated process, and almost all market makers are in partnership with large trading companies who have off-the-trading-floor computers.  The market makers make the trades and then forget about them.  The 'computer' is programmed to find the smartest hedges – once they have a new position.  In fact, the computer manages the portfolio and even makes trades when there is a way to add some edge (profit potential) to the position.

Don't be concerned with the people who buy the options that you, or anyone else sells.  They can take care of themselves.

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