Many investors have never even heard of stock options selling. For most people options trading is synonymous with risk and potential big profits or losses, using leverage by buying options. However, a lot of savvy investors use strategies involving selling options, also known as options writing, to hedge existing positions against the possibility that the stocks that they already own, or are short, will move against them.
Now hedging with options is nowhere near as exciting as leveraging with options and doubling or tripling your money quickly. Perhaps this is the reason you don’t get the details of options selling explained as frequently in books or on websites on stock options basics. It certainly is a lot more exciting than losing all the money that you have put into a long option position though, which happens all too often unfortunately!
Selling Options Equals Writing Options
Before we proceed it must be clear to you that writing options is the same as selling them. Got it? Great! Now, by writing puts and calls you can benefit from the fact that the great majority of long put and call positions, i.e. where put/call contracts are bought, are losing bets for the buyers. When an investor engages in writing options, he attempts to make money in a way that is exactly the opposite of buying options. In a nutshell, the options seller takes the other side of the buyer’s much riskier position. Perhaps it makes sense that selling options in this way he has an inverse likelihood of profiting. The risk, as well as the potential gain, is smaller. However, the potential for gain is greater, and many good investors will take consistent gains over a mix of big wins and frequent losses of an entire position.
Example time. I will talk here about writing calls against stock that you own. The mechanics are the same if you write puts against stock that you are short, only the directional movements are reversed for writing puts.
It is April and you own 100 shares of ABC, which is trading at the moment at $33 per share. You feel good because you were right about the stock, having bought at $25. You don’t think it’s done moving up though, and you have no intention of selling at $33. At the same time you recognize that a pullback or some consolidation might be in order, and you would appreciate a way to reap some of the benefit from this position without actually selling your shares. Selling options against your shares is the perfect way to do this. You can sell one ABC August 35 call, at $1.50, let’s say. You are selling someone the right to buy 100 shares of ABC at 35 by the end of the third week in August, and for this you are paid $150 in this case ($1.50 X the 100 shares that the contract represents).
The person on the other side of the transaction, the call buyer, has paid a relatively small amount of money for an out-of-the-money option that may very well expire worthless, in the hope that the stock will continue its upward rise and give him a very high percentage gain. In addition to the possibility that the option will become in-the-money and have intrinsic value, he also would benefit by having the stock move as soon as possible so that he may sell before time decay hurts the value of his option too much.
As the option seller you accept an amount that is small relative to the size of your position ($3300 at the moment), but it functions as a small insurance policy protecting you in case the stock does have a pullback from $33, temporary or otherwise. The $150 premium you receive lowers the cost basis of the position for you. You bought at $25, but now this position has cost you $23.5, or $2350.
If the stock is below $35 per share on expiration day, roughly 4 months from now in August, you keep your ABC stock as well as the premium amount. Over the four months that premium represents approximately a 13% annualized return (150*(12/4)/3300=~13%).
What if the stock price is above the strike price on expiration day? Well, you must deliver 100 shares of ABC at $35 per share. Having bought the stock at 25, you are still pretty happy, but the critical thing to recognize is that if the stock keeps going past $35 a share you would have missed out on any move above $35 directly because of the insurance that you purchased to guard against a drop back in the price of the shares. Still, another thing in your favor is also the premium amount that you get to keep.
Note the clean inverse relationship between the motivations of the options buyer and option seller, and the ways in which each stands to benefit.
The option seller wants to hedge and is happy with a small return relative to the size of his existing position. Time decay is his friend; all else being equal, the price of closing his position before expiration goes down each day, until expiration when the option expires worthless (if it’s out of the money) and he keeps 100% of the premium and his shares, or (if the option is in the money) is forced to sell his shares at a gain while still keeping the premium he received.
The options buyer uses leverage for a possible large percentage return. The passage of time will work against the value of his position (notwithstanding volatility and other factors beyond the scope of this article).
That is the basics of stock options selling explained. If you do your homework you might find that writing covered options gives you a fairly good shot at making relatively small but consistent gains over time.
Why do I say “covered” options? What are covered calls and puts and why the qualification?
A covered call writer owns 100 shares of the underlying security against which the call is written, for each call that he has written. (A covered put seller is short 100 shares of the underlying security for each put he writes) You could establish a covered options position by selling a call or put contract against a stock position (long or short, respectively) that you already have established, as in our example, or you could buy or short shares at the same time as you write an option against them.
Writing uncovered or naked options means that you do not own the underlying shares, if you are writing calls, or you are not short the underlying shares if you are writing puts.
So what’s the big deal about naked puts and calls? In a word, risk. There is a huge difference between selling “covered” options versus selling “uncovered” or “naked” options, in terms of risk between the two. A risk continuum is a good way to explain option trading.
As a call option contract gives you the right to buy 100 shares (or for puts, to sell 100 shares) of the underlying security at a given price on a given date in the future, there must be a place from which these shares are delivered (or a counterparty who will buy the shares, for puts) if the option is in-the-money on expiration day.
As the options writer or seller, you have been paid an amount of money, a premium, to assume that responsibility. If the option is exercised and you do not already have the shares in your account as a call seller (or if you are not already short the shares as a put seller), delivery of 100 shares for every call contract that you have written (or purchase of 100 shares for each put you wrote) would be a relatively large, immediate expense to you.
But the real problem here, for a naked call position that goes against you, is that you would be forced to purchase shares at the current market price and sell them immediately at the strike price, which would be below (and maybe far below!) the current price of the stock in the case of an in-the-money call. For a naked put position whose strike price is higher than the stock price by expiration day, you would have to buy 100 shares for each contract that you have written, at a higher price at which you can currently buy the stock.
For calls, you would immediately lose the difference between the strike price and the price at which you may currently buy the shares in order to fulfill your obligation to deliver. For a naked put position that goes against you, you must buy the stock that the put buyer owns the right to sell (a terrible sentence I know; I hope it makes sense). The bottom line is that no one should ever tell you that option trading strategies involving selling options are always safe.
This is one case where writing naked puts and naked calls have different outcomes if the trade goes against you: when your naked put position concludes at a loss it is only a paper loss. Buying the shares at the strike, higher than the current market price, leaves you with those shares. With naked calls, immediate delivery equals an immediate loss.
Either way, if you have many contracts this could add up to a lot of money, especially when compared to the relatively small amount that you received for writing the options. Brokerage firms will require that you have money enough in your account to cover (literally) naked options positions that go against you, in lieu of owning the shares. There is a possibility that even a option contract that was far out-of-the money when you wrote it could expire in-the-money. You must show a way to address this possibility, whether through cash in your account, equity, or by simply owning (or having short) shares of the underlying stock equal to the shares represented by the contract(s) that you have written (i.e. covered puts or calls).
To circle back a little, hopefully you can see clearly now why writing covered puts, against shares that we are short, provides us with a little safety against an upward spike, by effectively raising the cost basis for our short. And, if the share price plummets and if we are forced to buy shares at the (higher) strike price at expiration, we are simply covering an existing short position at a profit. It’s the inverse outcome of a covered call position where the stock price rockets higher. We have lost only the opportunity cost of missing the big move, in return for the insurance of the call, or put, that we would have been better off not writing. Having naked options positions go against us leaves us facing a very different type of music, though maybe slightly less dire in the case of naked puts, as we can theoretically hold our newly purchased stock until it comes back…
So to recap, the options seller, as he is hedging with options, normally trades away the prospect of benefiting if his underlying long or short position runs far in his favor, i.e. beyond the strike price of the option he writes. In return he receives the premium from the options buyer, which can be though of as insurance against a the stock moving against him (as it reduces his cost basis), and a simple windfall if the stock trades sideways. Keeping the proceeds from these premium amounts if positions work out in your favor can give you very respectable gains, though really never triple-digit home runs as can happen with long option positions. Sometimes sophisticated investors establish naked options positions, but they are quite speculative and require sophistication and financial wherewithal. To be clear: selling options for safety means that you will always own the underlying stock.
In the real world, writing options is especially well-suited to investors with large portfolios who would like to protect paper gains that they might have, or reduce their cost basis when they open up a position. The benefits of selling options must always be weighed against the fact that they reduce the potential profit of a given long or short stock position. Sometimes letting a stock continue to move in your favor with a trailing stop is a good way to have a nice gain turn into a huge gain, even without leverage. Capping a position’s potential gains by selling an option against it is probably not a strategy you should use for every single stock that you buy or short. There are many strategies one may use with covered options; another good one is writing naked puts to buy a stock lower than its current price, or simply pocket the premium if it never gets there before expiration.
Even though writing options (at least covered options) is safer than buying options, it’s not for everyone. Having stock options explained to to you properly, as I hope I’ve done, does not reduce the risk of trading them. Please consult a financial professional before investing in them, and if you are of a conservative mindset get options trading explained to you with an emphasis on options selling.