In our introduction to options, we talked about what options are and we did some examples of buying options.
But you can also sell options, which is also referred to as writing or shorting.
In this article we’re going to cover selling call options, and selling put options.
The Difference Between Having the Right and Having the Obligation
When you buy an option, you have the right but not the obligation to buy or sell the underlying asset.
When you sell (write or short) an option, you have the obligation to buy or sell the underlying asset if you are “assigned” up to and including the expiration date.
Remember, you don’t need to own any shares of a stock when buying or selling options.
Option traders typically don’t want to own the stock. They just want to trade the option contracts. If you buy an option you can sell it at any time, and if you sell an option, you can buy it back and effectively close out the position at any time.
Here’s a quick review of the terms associated with buying options:
- Call Options: The buyer has the right to buy a stock at a predetermined price (strike price / exercise price) within a set time frame (expiration date).
- Put Options: The buyer has the right to sell a stock at a predetermined price (strike price / exercise price) within a set time frame (expiration date).
- The cost of an option is called the premium. Learn about option prices here.
- 1 option contract usually represents 100 shares.
Read the full introduction to options article here.
What Does Assigned Mean?
Assignment happens to sellers.
If a seller is assigned on a call they have sold, they are obligated to deliver/sell the underlying.
If they’re assigned on a put they have sold, the seller is obligated to buy the underlying.
Selling Call Options: Covered and Naked
What is a covered call and naked call?
A covered call is when you sell a call option on a stock that you own. You are “covered” because you own the 100 shares. If you are “assigned” and you need to deliver the 100 shares to the option buyer, you can do so.
A naked call involves selling a call option without owning the stock (underlying asset). This is more risky because if the option is exercised when the stock is much higher than the strike price, then you’re forced to buy the stock and deliver/sell it to the option buyer at the lower strike price.
Why Would You Sell a Call Option?
When you sell an option, you get the premium. So it’s firstly a way to generate income. But this income comes with the obligation to sell 100 shares of the stock at the strike price.
As a call seller, you want the stock price to remain the same or go down. This way the option will expire worthless, it won’t be exercised, and you simply keep the premium you received when you sold the option.
When you sell a call option, you have limited reward (premium) and a lot of risk. This is why you don’t want to sell a call naked. You want to be covered. You want to already own the 100 shares. If you don’t own the shares you are naked and you’re exposed to a lot of risk. If the stock price goes up you are obligated to buy it at a high price, and sell it at the lower strike price.
So if you’re more bearish on a stock you can make money selling a call option.
Keep in mind, some traders will have strategies they are successful with when selling calls naked. There are many ways to make money in the market. Depending on who you learn this information from, you will find biases in their strategy recommendations.
Selling Put Options: Cash Secured Puts
When you sell a put, you are obligated to buy the shares at the strike price.
If the stock price goes up or remains the same, the option will expire worthless. You will no longer be obligated to buy the shares and you will keep the premium.
If the stock price falls below the strike price, you essentially are in a losing position. You are obligated to buy the shares at the strike price, even though they are selling for less on the market.
Why Would You Sell a Put Option?
It can be risky to sell a put when you don’t have the intention of buying the stock. If an option is exercised you as the seller are obligated to buy the shares. If you buy the shares at the strike price and do not want to hold them, you will be selling them at the market price which is lower than the strike price. Therefore you’re taking a loss.
It’s less risky to sell put option on a stock you will be happy to purchase at the strike price. You gain the premium, and if you’re assigned to buy the shares (if the option is exercised), then you will be fine with buying the stock.
If you sell puts on a fundamentally strong company you will most likely not lose as their stock price will eventually rise back up.
A cash secured put refers to a put you sell with the cash on hand to buy the shares if it is exercised. You have cash and are willing to buy the shares at the strike price.
If you don’t have the cash on hand and the intention to buy the shares if the option is exercised, you might need to close out your position. If the stock has fallen below the strike price, this will lead to a loss. Here’s how it works:
Closing Out Your Positions
When you sell an option, you are essentially taking on an obligation.
In the case of selling a put option, you are agreeing to buy the underlying shares at the strike price if the option is exercised. This is known as being “short” the put option. Same thing applies to a call option.
When you sell a call option, you are agreeing to sell the underlying shares at the strike price if the option is exercised. This is known as being “short” the call option.
However, you can close this short position by buying back the same type of option you initially sold. This is called a buy-to-close (BTC) order. When you buy back the option, you are effectively canceling your obligation to buy or sell the underlying shares. The obligation is then transferred to the new holder of the short put position, which is the person from whom you bought back the option.
In other words, by buying back the option, you are no longer responsible for fulfilling the terms of the contract if the original buyer decides to exercise the option. The new seller (the person from whom you bought back the option) now assumes the obligation to buy the shares at the strike price if the option is exercised.
For the put option example, if the stock went down below the strike price, you will be buying back the option and closing your position for more than the premium you received when you sold the put to begin with. This is where you can lose on this trade.
Most Traders Don’t Exercise Options
It’s important to remember that in many cases traders won’t exercise an option.
- If you buy an option and it increases in value you can sell it.
- If you buy an option and it decreases in value, you can sell it before it expires worthless.
- If you sell an option and the trade goes your way you will simply keep the premium.
- If you sell an option and it decreases in value, you can buy it back and close the position.
If you can walk through all the scenarios of trading options, you will really start to understand how these work.
How to Profit or Lose from Call Options
If you buy a call option and the stock goes up, you can sell the option for a gain. You profit when the stock goes up.
If the stock remains the same or goes down, the option expires worthless and the most you lose is the premium you paid. You could sell the option before it expires to incur a smaller loss.
If you sell a call option and the price remains the same or goes down, the option will expire worthless and you keep the premium. You can also buy the option back whenever you want at a cheaper price and close out your position with a gain. As a call seller you profit when the stock goes down or remains the same.
If the stock goes up the call buyer might exercise the option. If the option is exercised you are obligated to sell 100 shares. If you own them (covered call) then you simply sell your shares. If you don’t own them (naked), you are forced to buy 100 shares at the market price and sell them at the lower strike price. You can buy back the option and close it out, however you will be buying it back for more than you sold it for and will incur a loss.
How to Profit or Lose from Put Options
When you buy a put option and the price of the stock goes down, the value of the option goes up. So you can simply sell your option. You profit when the stock goes down.
If the stock remains the same or goes up, the put option would expire worthless. The most you lose is the premium you paid. You could sell the option before the expiry date to gain a bit back, however it will be for less than you paid as the value of the option has decreased.
If you sell a put or “write/short a put”, you will receive the premium. You’re the seller of the contract so you earn the premium right away. If the stock remains the same or goes up, the option will expire worthless and you profit from the premium. As the value of the put falls, you could buy it back and close out your position.
If the price of the stock goes down, the value of the option goes up. So in order to close your position you would need to buy the put back at a higher price and incur a loss. You would buy it back for higher than the premium you received when you sold it.
If the price of the stock goes down and the option is exercised (or you let it expire without buying it back), you have the obligation to buy the shares at the strike price. If you have the cash on had (cash secured put), you would simply buy the 100 shares at the strike price. This is why it’s safer to sell puts on strong companies because their stock price should rise back up eventually.
