Options: How are they financially backed?

I saw a statistic that approximately 60% of options are closed out, 30% expire worthless, and only 10% are actually exercised. As long as options traders are making a profit (the fact that they exist assumes they are), then these closed out options are drawing extremely large sums of money out of some unknown place. Where is this money coming from? Thanks!

First, you need to understand that options are a "zero-sum" system. For each dollar one person makes on an option another person loses one dollar. This is true because for every long position there is an offsetting short position. So, you can say the profits that some people make are financed by the losses others experience. If you add all the profits and losses from options trades, ignoring the "friction" caused by commissions and fees, the sum will be zero.

However, options do not trade in a vacuum. As a result, it is possible for both the seller and the buyer of an option to make a profit. A simple example is a covered call. Suppose I just bought 100 shares of XYZ stock for $50 per share and I decide I want to sell it if it is trading at or above $55 per share a month from now. I decide sell a call option with a $55 strike price for a $1 per share premium. For our example, let's say Harold bought the option I sold for $1 per share. Now assume that at expiration one month from now the stock is trading at $60 per share. Harold exercises the option, buys the stock from me for $55 per share, and promptly sells the stock for the $60 per share.

My profit per share was

$55 + $1 - $50 = $6 per share.

Harold's profit per share was

$60 - $1 - $55 = $4 per share.

If you just look at the option it was worth $5 when Harold exercised it, so I lost $4 per share on the option and Harold made $4 per share on the option, giving the zero sum. However, when you include the stock profits we both made money and it was not a zero-sum system.

So, the answer to "where does the money come from" is that the money comes from other option traders.

The question "How are they financially backed?" is a different issue. Options are backed at three levels. First is the individual trader. If I write an option I am assuming financial responsibility for fulfilling my obligation if assigned. Second is my brokerage. If I do not fulfill my obligation my brokerage is required to fulfill it. Third and finally is the Option Clearing Corporation or OCC. If neither I nor my broker fulfill my obligation, the OCC is required to fulfill it.

BTW, there is not such thing as the "Options Clearing Council" reference in a previous response.

Options are backed by the OCC option clearing corporation. The stats you saw are relatively correct. Closing out and option is doing the opposite from what you started with. Money is changing hands from investor to investor. Money isn't just created and given out. If I want to sell options someone has to be willing and able to buy the options I want to sell just like the stock exchanges.

The money comes from the Options Clearing Council, the exchange, the brokers who pay the investors or traders - which really, ultimately, comes from other invetors and traders.

You "get more bang for the buck" trading options.

Options have the element of time and time decay goping against them.

The losses are already known. A trader KNOWS he/she cannot lose any more than the cost of the option.

To learn more about options trading, here's a free AND VERY helpful site:
http://optionseducation.org

That site basically "spoon feeds" those folks who would like to learn more about trading options.

Thanks for asking your Q! I enjoyed answering it!

VTY,
Ron Berue
Yes, that is my real last name!

Options are cash settlement (T+1)

Closed out means that the seller is buying it back and the buyer is selling it back. They are reversing the path of money used to open the positions. If someone is paying more than the got when they sold, they either use money prom profitable positions or risk capital.