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I have only taken one introduction class in finance. However we came along opinions, their pricing, etc. We only contemplated being the buyer of a option. If everything works for you apparently you can earn a high yield. Thus I'm wondering why a bank (or another institution) would offer options. Say there's a stock which costs \$100. The bank offers a (European) call with a striking price of \$95, so you'll pay \$5 for the option (I know there're other factors which determine the price but want to neglect them here to keep it simple). After a certain amount of time the option matures while the stock is at \$110. The bank owes you \$15 (in case of cash settlement which should be the default case in the real world). They sold it for only $5 though and lost money.

So, why would a bank issue the option at all? One may argue because they expect the stock to fall but often they do offer both put and call options and on the put option they would only earn what they can sell it for in this case.

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closed as off-topic by vonjd, Bob Jansen Dec 10 '15 at 17:01

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    $\begingroup$ Hi jp_, welcome to Quant.SE! The answer you received is very nice but the question is off-topic here. $\endgroup$ – Bob Jansen Dec 10 '15 at 17:01
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You are neglecting several other things. (1) That deep in the money option is worth far more than 5 USD. (2) The fair price will actually take into account the probability that the stock will rise to $110 at maturity. (3) Also the bank might be hedging some other positions, such as a short call with that long call.

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  • $\begingroup$ Thanks for the answer. Concerning the first two points, can we imagine it like an auction similar to an IPO? The bank tries to figure out the highest price buyers are willing to pay and sells it at that price. $\endgroup$ – jp_ Dec 10 '15 at 13:37
  • $\begingroup$ No. An IPO is a one-off event. You cannot IPO the same company twice (at least without delisting in between). But you can sell a Call option as many times you want. On that sense is not much an IPO auction (as you put it) but an Walrasian Auction with multiple buyers and sellers and a price that clears the market. $\endgroup$ – phdstudent Dec 10 '15 at 13:42
  • $\begingroup$ Ok. Sorry my comparison was misleading. Of course you can only go public once. The main thing I wanted to emphasize on is that it works like an auction. $\endgroup$ – jp_ Dec 10 '15 at 13:44
  • $\begingroup$ Walrasian auction. Not an auction in the sense you are thinking about. $\endgroup$ – phdstudent Dec 10 '15 at 13:46
  • $\begingroup$ Yes. Participants determine how much they'll but and sell given a price and the aim is to have an equilibrium. $\endgroup$ – jp_ Dec 10 '15 at 13:48

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