by Ian Harvey
When selling options, as when buying options, there are many strategies that can be employed. There are two main streams of traders – those that are bullish – who will buy a call or sell a put; and those that are bearish – who will buy a put or sell a call.
However, options trading tend to favor the options seller, as selling options is a positive theta trade. Positive theta means the time value in stocks will melt in the seller’s favor. But with this strategy comes added risk and responsibility.
Definition of Selling Options
Selling options is another strategy for traders to use when trading on the stock market. “Selling options” is often referred to as “writing options”.
To sell – or “write” -- a call or put option you are selling a buyer the right to purchase stock from you at a specified strike price for a specified period of time.
The basic idea behind the option selling strategy is to hope that the options you sold expire worthless so that you can pocket the premiums as profits.
However, it is important to remember that, in contrast to buying options, selling stock options does come with an obligation - the obligation to sell the underlying equity to a buyer if that buyer decides to exercise the option and you are "assigned" the exercise obligation.
Selling Options Strategies
Selling Call Options
Writing Covered Calls – this is one of the most popular options selling strategies. In a covered call, you are selling the right to buy an equity that you own.
If a buyer decides to exercise his or her option to buy the underlying equity, you are obligated to sell to them at the strike price - whether the strike price is higher or lower than your original cost for the equity.
Sometimes an investor may buy an equity and simultaneously sell (or write) a call on the equity. This is referred to as a "buy-write."
Writing Uncovered or “Naked” Calls – is a high risk strategy that can be used when the option trader is very bearish on the underlying. In an uncovered call, you are selling the right to buy an equity you which you don’t actually own at the time. Therefore, before starting to sell uncovered calls, the trader must be approved by the brokerage as having sufficient knowledge, trading experience and financial resources.
Writing Ratio Calls -- a combination of covered calls and naked calls.
Writing Covered Puts – this strategy is usually used if the trader is bearish on the underlying, and also has a short position in the underlying. The covered put has a similar pay-out as a naked call; and is seldom employed because…..
Writing Naked Puts -- is a high risk strategy that can be used when the option trader is very bullish on the underlying. Selling naked puts implies the trader uses a high degree of leverage in a margin account and does not hold enough available cash to buy the underlying asset at the short put strike price.
Writing Ratio Puts – is a combination of covered and uncovered puts. This strategy is rarely used but has the same risk/reward profile as writing ratio calls.
Writing Put Spreads – is similar to writing ratio puts; but involves an options strategy in which an equal number of put option contracts are bought and sold simultaneously on the same underlying security but with different strike prices and/or expiration dates.
To re-iterate, it is important to remember that, in contrast to buying options, selling stock options does come with an obligation.
Selling a call option has the theoretical risk of the stock climbing extremely high – which then becomes costly to cover – even though this is not a frequent event. And, there is no upside protection to stop the loss if the stock rallies higher.
Looking at the reverse of this, selling a put option has the risk of the stock falling.
One method to alleviate too much risk is to determine a price in which you may choose to buy back the put if the stock falls, or the call if the stock climbs; or hedge the position with a multi-leg option spread.
Another situation to be aware of is when an option seller may be short on a contract and then experience a rise in demand for contracts, which, in turn, inflates the price of the premium and may cause a loss, even if the stock hasn't moved.
Many traders avoid becoming involved in selling options due to the risks that could be encountered; even though the likelihood of this scenario taking place is considered small.
Obviously having the stock price stay in the same area or having it move in your favor will be an important part of your success as an option seller.
Selling options does not have the same kind of excitement as that of buying options. Even though selling options is a popular trading technique to enhance the returns on one’s portfolio, it is necessary that this type of trading is performed on a selective basis. Selling premiums can prove successful; however, if you don’t follow some very specific guidelines, your long-term chance of profitability is unlikely.