Parties to Options – Holder, Writer & their Payoffs

1. Introduction

In an Option contract, the two parties are not equal. One has the power (Right), and the other has the burden (Obligation).

2. The Two Parties

A. Option Holder (Buyer)

• Role: Buys the option by paying the Premium.
• Power: Has the Right to exercise.
• Risk Profile:
  • Max Loss: Limited to Premium paid. (If he doesn't exercise, he only loses the premium).
  • Max Profit: Unlimited. (As market moves in his favor).

B. Option Writer (Seller)

• Role: Sells the option and receives the Premium.
• Burden: Has the Obligation to fulfill if the holder exercises.
• Risk Profile:
  • Max Profit: Limited to Premium received. (He can never make more than the price he managed to sell it for).
  • Max Loss: Unlimited. (If market moves against him, he has to pay up).

3. Comparison Table: Holder vs Writer

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4. Exam Notes: Writing the Answer

Question: "Who are the parties to an Option contract? Discuss their risk profile." (10 Marks)

Answering Structure:

1. Identify: Start with "Holder (Buyer)" and "Writer (Seller)".
2. Premium: Explain that Premium flows from Holder to Writer.
3. Risk: Crucial point—Holder has Limited Loss, Writer has Unlimited Loss.
4. Diagram: Draw a simple payoff graph (Hockey stick shape).

5. Quiz Time! 🎯

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