In this yield-seeking environment, selling options is a strategy designed to generate current income.
If sold options expire worthless, the seller gets to keep the money received for selling them. However, selling options is slightly more complex than buying options, and can involve additional risk. Here is a look at how to sell options, and some strategies that involve selling calls and puts.
The ins and outs of selling options
The buyer of options has the right, but not the obligation, to buy or sell an underlying security at a specified strike price, while a seller is obligated to buy or sell an underlying security at a specified strike price if the buyer chooses to exercise the option. For every option buyer, there must be a seller.
There are several decisions that must be made before selling options. These include:
- What security to sell options on (i.e., shares of XYZ Company)
- The type of option (call or put)
- The type of order (market, limit, stop-loss, stop-limit, trailing-stop-loss, or trailing-stop-limit)
- Trade amount that can be supported
- The number of options to sell
- The expiration month*
With this information, a trader would go into his or her brokerage account, select a security and go to an options chain. Once an option has been selected, the trader would go to the options trade ticket and enter a sell to open order to sell options. Then, he or she would make the appropriate selections (type of option, order type, number of options, and expiration month) to place the order.
Selling options involves covered and uncovered strategies. A covered call, for instance, involves selling call options on a stock that is already owned. The intent of a covered call strategy is to generate income on an owned stock, which the seller expects will not rise significantly during the life of the options contract.
Let’s take a look at a covered call example. Assume an investor owns shares of XYZ Company and wants to maintain ownership as of February 1. The trader expects one of the following things to happen over the next 3 months: the price of the stock is going to remain unchanged, rise slightly, or decline slightly. To capitalize on this expectation, a trader could sell April call options to collect income with the anticipation that the stock will close below the call strike at expiration and the option will expire worthless. This strategy is considered "covered" because the 2 positions (owning the stock and selling calls) are offsetting.
Although there is still significant risk, selling covered options is a less risky strategy than selling uncovered (also known as naked) positions because covered strategies are usually offsetting. In our covered call example, if the stock price rises, the XYZ shares that the investor owns will increase in value. If the stock rises in value above the strike price, the option may be exercised and the stock called away. Thus selling a covered call limits the price appreciation of the underlying stock. Conversely, if the stock price falls, there is an increased probability that the seller of the XYZ call options will get to keep the premium.
Uncovered strategies involve selling options on a security that is not owned. In our example above, an uncovered position would involve selling April call options on a stock the investor does not own.
Selling uncovered calls involves unlimited risk because the underlying asset could theoretically increase indefinitely. If assigned, the seller would be short stock. They would then be obligated to buy the security on the open market at rising prices to deliver it to the buyer exercising the call at the strike price.
The intent of selling puts is the same as that of selling calls; the goal is for the options to expire worthless. The strategy of selling uncovered puts, more commonly known as naked puts, involves selling puts on a security that is not being shorted at the same time. The seller of a naked put anticipates the underlying asset will increase in price so that the put will expire worthless.
Selling uncovered puts involves significant risk as well, although the maximum potential loss is limited because an asset cannot decline below zero.
There is another reason someone might want to sell puts. An investor with a longer-term perspective might be interested in buying stock of a company, but might wish to do so at a lower price. By selling a put option, the investor can accomplish several goals.
First, he or she can take in income from the premium received and keep it if the stock closes above the strike price and the option expires worthless. However, if the stock declines in value, and the owner of the option exercises the put, the seller will have purchased the stock at a lower price (strike price minus premium received) than if that investor had bought it when he or she sold the option. If the stock falls below the break-even price of the assigned shares, losses may occur.
With the knowledge of how to sell options, you can consider implementing more advanced options trading strategies. Selling options is crucial to a number of other more advanced strategies, such as spreads, straddles, and condors.
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