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In his book 'options, futures and other derivatives', John hull writes:

Derivatives such as forwards, futures, swaps, and options are concerned with transfer- ring risk from one entity in the economy to another.

Let us take a call option. If I buy a call option, who did I transfer risk to? Or did someone else transfer his or her risk to me?

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By buying the call option, you are getting the benefit of purchasing the underlying shares (that is, if the shares go up in value, you make money), but transferring the risk of the shares reducing in value.

This is more apparent when you are using the option to offset an explicit risk that you hold. For example, if you have a short position, you are at unlimited risk of the position going up in value. You could decide you only want to take the risk that it might rise to $X. In that case, you could buy a call option with $X strike price. Then you have transferred the risk that the position goes over $X to the counterpart, since, even if the shares are trading at $X+$Y you can close out the short position by purchasing the shares at $X, while the option counterpart will lose $Y.

  • The call option you bought was written by someone else who sold the option to you. Usually they own the shares already (a "covered call") and they are risking the upside of the stock increasing in value beyond the strike price. Only one of you is going to win on the option, although the writer of an executed covered call just lost out on additional gains. – Rocky Feb 7 '15 at 22:49
  • @Rocky the writer may not care, they might prefer to know that they at least have a seller at the strike price and some cash in the form of the cost of the option if the stock drops below that. – serakfalcon Feb 12 '15 at 19:01
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When you buy a call option, you transfer the risk to the owner of the asset. They are risking losing out on gains that may accumulate in addition to the strike price and paid premium.

For example, if you buy a $25 call option on stock XYZ for $1 per contract, then any additional gain above $26 per share of XYZ is missed out on by the owner of the stock and solely benefits the option holder.

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The important thing to realize is, what would you do, if you didn't have the call? If you didn't have call options, but you wanted to have a position in that particular stock, you would have to actually purchase it. But, having purchased the shares, you are at risk to lose up to the entire value of them-- if the company folded or something like that.

A call option reduces the potential loss, since you are at worst only out the cost of the call, and you also lose a little on the upside, since you had to pay for the call, which will certainly have some premium over buying the underlying share directly. Risk can be defined as reducing the variability of outcomes, so since calls/shorts etc. reduce potential losses and also slightly reduce potential gains, they pretty much by definition reduce risk.

It's also worth noting, that when you buy a call, the seller could also be seen as hedging the risk of price decreases while also guaranteeing that they have a buyer at a certain price. So, they may be more concerned about having cash flow at the right time, while at the same time reducing the cost of the share losing in value than they are losing the potential upside if you do exercise the option.

Shorts work in the same way but opposite direction to calls, and forwards and futures contracts are more about cash flow management: making sure you have the right amount of money in the right currency at the right time regardless of changes in the costs of raw materials or currencies. While either party may lose on the transaction due to price fluctuations, both parties stand to gain by being able to know exactly what they will get, and exactly what they will have to pay for it, so that certainty is worth something, and certainly better for some firms than leaving positions exposed. Of course you can use them for speculative purposes, and a good number of firms/people do but that's not really why they were invented.

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