Why Options Selling Increases Safety

If you are a new investor looking to diversify your portfolio for the sake of safety, chances are you haven’t really taken a look at stock options for a couple of reasons. First, you might be a little intimidated by the complexity of options. Secondly, you probably associate options with a high level of risk, and this gives you little incentive to scale a learning curve as you’re interested in protecting your money in these uncertain times.

The thing is that buying stock options is only one option trading strategy you can use. Instead of buying an option, which is the right to purchase 100 shares of the stock at a given price point by a certain date in the future, you can take the other side of the trade and sell an option contract that covers shares that you already own. Options selling is usually overlooked by new investors, and this is a mistake.

Here’s what you need to know: options selling means is that the option buyer pays you a small amount of money-known as the premium-for the right to purchase your shares at a given ‘strike’ price, usually a higher price than where the stock is currently trading. If the stock reaches that price before the expiration date the option buyer has the right to purchase your shares at the agreed-to price. Now if the stock continues up beyond the strike price before expiration, you have still benefited by the move in the stock between where it was when you sold the option contract and the price at which the option buyer bought the right to purchase the shares from you. You also, as the option seller, get to keep the option premium that the buyer paid you.

This doesn’t sound very risky does it? The answer is that it is not risky. There are, however, two potential downsides to this scenario if you are selling options. One is that you do not participate in any upward move in the stock above the strike price, at which you sold the right to purchase your shares. For example if you sold the option buyer the right to buy your shares at $100 per share when the stock was trading at $90 per share, if the stock is trading at $120 per share by expiration you must sell your shares at $100 (but you have still profited from the move between $90 and $100).

The other potential downside for you as the seller of the option is that the stock price may fall. Between now and the expiration date the stock may very well be trading lower than where it was priced when you sold the option. But in this case you’re still better off than if you had simply held onto your shares rather than selling the option, as again, remember that with options selling you get to keep the premium amount that the buyer paid you, and you get to keep your shares as the right to buy them at the now far-off strike price is worthless. You have a paper loss on the shares that you own, but your cost basis for the shares is slightly lower due to the premium amount paid by the buyer, that you get to keep.

I hope I’ve shown that there is more to options trading than just taking a gamble. The fact is that many savvy investors use options selling to create an income from their existing portfolio by selling, aka writing options against shares that they already own. As you get stock options explained to you further be sure and paper trade them for a while before actually committing any real money. The options market moves very quickly and the relationship between option premium prices than that of the underlying stock is not always clear cut.