Buying options and selling options makes up the core of every options contract. Every option contract requires both a buyer and a seller. Sellers of options have the trading odds in their favor because most options contracts expire worthless. Just because you have the trading odds in favor it doesn’t mean that you should be a seller of naked options. Selling naked options is the riskiest trading strategy, even riskier than buying naked calls and puts. The safe way to be a seller of options is with spreads.
The process of selling options is very simple. Every options contract requires both a buyer and a seller. Selling an options contract is taking the inverse position of an options buyer. Your broker does the automated process for you. All you need to know is the strategy that you’re looking to implement.
Whether it’s selling options for income, protecting your portfolio, or for sheer speculation, a strategy exists to help you succeed. Learn how selling options is a safer strategy than buying them. First, let’s define what options are. They’re derivatives based on securities like stocks. Also, options are a contract between a seller, also known as the “writer,” and a buyer also known as the “holder.” In other words, options give you the right but not the obligation to buy or sell a stock at a set price within a certain time frame.
One options contract represents 100 shares. In fact, options are a great way to grow a small account. You’re able to trade the large cap stocks without having to put up the money.
Therefore, you’re protecting your account more so than you would be with a penny stocks list. However, keep in mind that there are many moving parts.
Options expire which is different than stocks. The contract expires if the underlying security doesn’t reach the strike price. There are two components to trading options; calls and puts.
As a result, you can sell either one. It simply depends on which direction you think the market is going; then you take the opposite stance.
Options give the holder the right to purchase the shares but with no obligation to do so. The holder obtains the right by paying a premium fee for each contract. This enables the holder the option to buy or sell the shares at a certain price up until the contract expires.
However, 80% of options expire without the holder exercising this right. Therefore, in most cases, the writer keeps the premium fee without buying or selling any shares.
The writer, on the other hand, is obligated to deliver on the contract if the holder exercises this right.
Selling Options Calls vs Selling Puts
Selling options as calls or puts depends on whether you believe the trade is bearish or bullish. As the contract writer, you want the option to expire worthless. Specifically, your objective is to keep the premium without buying or selling shares. It’s one of those rare moments time decay works in your favor.
Buying calls and puts is the most well known options strategy. In fact, our trading service goes in depth with buying calls and puts.
Buying calls and puts is the most basic options trading strategy. While it can be quite lucrative, it’s also quite risky. Therefore, selling options was developed.
However, selling options can still be quite risky. Although, since 80% of options expire worthless, the seller is the one that benefits.
Selling vs Buying With Calls and Puts
When you sell a call option, you’re taking a bearish trade. You have to train yourself to take the opposite trade. Since you think the stock is going down, you hope to attract someone who thinks it’s going up.
In other words, buying a call is the bullish play whereas, selling a call is the bearish play. It might be confusing at first so make sure to practice.
For example, let’s say that a stock is trading at $20 per share. Then suppose you set a strike price of $23 and a one-month expiration date for a call option.
Next, let’s say a holder pays you a premium of $1 per share, totaling $100 since a contract is 100 shares. If the price of the stock never goes above $23 before the contract expires, then you keep the $100 premium. That’s it. You made $100 and didn’t have to relinquish any stock.
What happens when you sell a call option if the stock goes the other way? If the price goes past $23 to $26, then the holder has the right to buy the shares at $23.
You still keep the $100 premium, but you must sell 100 shares valued at $26 for $23 per share. The $3 difference times 100 shares equals $300. Subtract the premium, and that’s a loss of $200.
The Risk of Selling Calls
As a call writer, you face a greater risk than a holder. The holder risks only the premium.
However, your risk is infinite if the stock price goes through the roof. In that case, you must either sell shares you already own or buy shares at the current price to sell at the strike price. The odds of such a huge loss are slim… yet possible.
As a result, you should be as sure as possible on the direction of a stock. We know it’s impossible to be 100% accurate on the direction of a trade at all times.
News moves markets. Therefore, you could have played a perfect setup and still had it go against you. However, as stated above, that is rare.
Selling Put Options
When selling put options, the principle remains the same but in reverse. You believe the trade is bullish, so you go bearish. How do you sell put options?
Instead of setting your strike price above the current stock price, you set it below. Then you wait for a bearish holder to take you up on your offer.
How do you make money selling put options? You profit the same way that you do with call options. Your objective is to receive the premium without buying shares at the strike price.
This Risk of Selling Puts
It’s risky to sell put options but not quite as risky as selling call options. The reason is that a stock price can’t fall below zero.
For example, let’s say a stock is trading at $14 per share, and you set your strike price at $12 for one contract. If it drops to zero, then you lose $1,400 minus the premium you received for that contract.
It’s important to be aware of the risk of selling options. However, don’t let that scare you away from selling them.
If you’re new to trading options, then it’s prudent to practice in a simulated trading account before using real money. ThinkorSwim offers the ability for paper trading options. Go to TD to try it.
We can’t express just how important paper trading is. It allows you to work out the kinks before using real money.
Since options have a lot of moving parts, practice is important. You can test the best strategy for your trading style without blowing up your account.
Once you’ve worked out a good strategy, start out small. When you’re comfortable trading with small positions, increase your size.
Following that method protects you and your brokerage account. You never go broke taking your profits.
So, In a Nutshell…
In a nutshell, when you:
- Buy a Call – You have the right, but no obligation, to buy a security at the writer’s strike price
- Buy a Put – You have the right, but no obligation, to sell a security at the writer’s strike price
- Sell a Call – You have an obligation to sell a security to the holder at your strike price
- Sell a Put – You have an obligation to buy a security from the holder at your strike price
Which is better buying or selling options? It depends on your objective. Many strategies exist to profit from options for both writers and holders.
Perhaps the market is falling, and you want to hedge your portfolio against losses. Or maybe you want to generate regular money by selling weekly put options for income.
Options enable the holder to control shares of securities with no obligation to buy or sell them. You only pay the premium to take control. Therefore, it’s cheaper than actually purchasing or selling the security itself.
Also, if the market goes against you as a holder, then you don’t have to buy or sell. You lose your premium without losing your shirt.
Options enable the writer to profit from earning premiums. When taking into account that 80% of options contracts expire worthlessly, that makes for attractive odds.
You can deploy any number of options strategies, like spreads, straddles, or strangles. Our options strategies course teaches a wealth of information on trading options.
Are you unsure when to buy options and when to sell? Or when to sell options before expiration? What is the role of the option greeks? What are iron butterflies?
How important are open interest and volume? What risk may your choice of expiration date pose? Sign up to find out. It’s free.
Selling options are a great way to take advantage of the high percentage of options expiring worthless. It’s important to practice the strategy ahead of time though so you know how to properly profit. If you have success in a practice account, there’s an excellent chance it translates into live trading.
If you need more help, take our options trading course.