Question

3. You are a portfolio manager and you are considering writing (selling) a large call option on your existing portfolio. Why would you do this and what is the basic trade-off you must consider in your decision whether to do this or not? 4. Why do you suppose that the most actively traded options tend to be those which are neither far out of the money, nor far in the money, but instead are those which are near the money?

Answer 1

3.

Selling call options on stocks that we own is known as selling covered calls and it is a well known options strategy. The primary reason for doing this is when we do not expect the stock price to go up very much till the expiry of the option. The advantage in selling the call option is that we would receive the call premium from the option buyer. Moreover since we do not expect the stock to rise much to the large (Out of the money) strike price that we choose to sell the option at, there is high probability that the option will expire worthless & thus it will not be exercised. So we will get to keep both of our stock & the option premium received which becomes our additional side income.

The basic trade-off in doing so is that if the stock price does indeed go up to or beyond the strike price at which we sold the option, so the buyer will exercise the option & we will need to give delivery of the stock at the strike price, thus forgoing the potential profit on our stock that we could have had if we had not sold the call option.

4.

The main reason due to which far in the money or out of money options are not traded much is simply the financial interests of buyers & sellers of options as given in following points:

a.) Option sellers, which are mainly large institutional sellers are not usually much interested in selling ITM (In the Money) options as there is lower probability of these options expiring worthless so there is lower probability that the institutional option sellers will be able to profit from such options.

b.) Far ITM option prices are usually much higher than near the money option prices making them less attractive to option buyers specially speculators who use options as speculative bet to try to profit from stock price movements.

c.) Far Out of the money (OTM) options have strike price well beyond the current stock price range so there is very low probability generally that stock price would move so much that these options would become profitable to the buyer. So buyers generally prefer near the money options which have a higher chance of becoming profitable for the option holder.