Options Education

Selling Options

Now that we have talked a bit about purchasing contacts let's take a look at writing or selling contracts.

Let us take a look back at our building the golf course example.

• We do not own the land.
• We have written a contract.
• We have sold it to someone else and collected a premium.
• We have the obligation side of the contract.
• The property is the underlying asset.
• The person on the other side of the contract, the buyer, chooses to exercise his/her right to own the land.
• To meet our obligation we now have to buy the land, we did not own it before, and deliver it to the exerciser.
• The profit or loss is determined by where the land was trading when we sold the right and where the land is trading when we had to deliver the land to the exerciser. This purchase price will be offset by the premium that we received from selling the original right to buy. 

Selling Calls

Selling naked calls is one of the riskiest strategies of all. The potential loss is unlimited.
The writer of naked calls remains completely exposed to upside risk. Nevertheless, if you are comfortable using this strategy, it is most effective using near term options because they decay more rapidly. And that's what you want. The faster these options become worthless, the better.

Example

Let's look at OEX trading at $401.77. By selling the 400 call for $5.00, you would receive the $500 option premium, your maximum profit. At expiration, if the stock is at or below 400, you keep the full $500. However, your profit disappears as the stock climbs toward $405. Above $405, your loss grows without limit.

Given the mounting losses apparent in the table below, it should be clear that naked call writing is an extremely risky strategy. Even the most bearish investor would do well to convert this position to a bear spread by buying an out-of-the money call. This would limit upside losses.

Selling Puts

Puts as a form of hedging

When we sell a put contract without owning it first we are doing a cash secured or naked put. We will have the obligation side of the contract because we sold someone the right to sell stock to us. We use this strategy to generate income or get paid to buy stock at a lower price than it is currently trading. It is considered higher risk than a covered call and is a more advanced strategy. It is a bull market strategy.

Using this strategy to buy a stock at a discount

The most basic investment strategy is to buy stock. However, there are occasions when the stock may appear attractive, but not at the current price. Have you ever said, "I want to buy this stock, but it is a bit too high for me to feel comfortable. If it pulls back a few dollars, I'd like to purchase it?"
Writing a put option is a great way to deal with this situation. By writing a put option we assume the obligation to buy the underlying security, if the purchaser of the option decides to exercise his right.
There are a few questions we should ask ourselves before proceeding with this strategy. First, is this a stock that we truly want to own? Second, do we have the cash or margin available to do so? Third, are we prepared to take upon us the risk of stock ownership? In other words, if the stock drops dramatically, would we still feel comfortable owning it? Fourth, if the stock is not put to us, are the option premiums collected worth our while?
Some investors are willing to acquire the stock at a discount. This investor likes the stock, but is not willing to purchase at $47.50. He would be willing to purchase the stock at $45 if it pulled back to that level and thinks that this might be likely. He can sell the $45 put contracts for $2, collect the premium and wait for the stock to pull back. If, as anticipated, the stock does pull back he can use the premium collected earlier to help purchase the stock. If the stock does not pull back the option will expire and the premium will be kept.

Selling Puts to Generate Income

Other investors sell puts in order to collect a premium. This person is much like the insurance underwriter. He is not expecting the stock to take a plunge, but is expecting the stock to rise in price or at least retain its current value. Stock XYZ is trading a $47.50 the investor sells a $45 put contract, he collects $2 (premium) per share for doing so. As the stock rises or stays flat the principle of time decay works in the advantage of the option seller. If the stock stays above $45, the option will expire worthless and the put seller will keep the premium collected. If the stock were to fall below $45, then he would have the obligation to purchase the stock at $45 even though the stock may be trading lower.
Three scenarios when one might sell a put.

1. If XYZ is trading at $43 and you expect it to rise, you could sell 1 XYZ JUN 40 PUT for $4. As long as XYZ traded at or above the $40 strike price, the put would not be exercised and you would keep the premium.
   
2. XYZ drops below $40, the put would be In-the-Money and would be exercised. As the option seller you would be assigned, forcing you to purchase 100 shares of XYZ at $40, or $4,000.
   
3. The risk scenario is where XYZ is trading at $30 when the option expires. The option would be exercised, and you would lose $6 per share. The $30 market value of the stock, minus the $40 strike price, plus the $4 you received for selling the put.
   

Did you notice the numbers in each example are exactly the same, even the outcomes are similar, but the mindset can be a bit different? The danger is that the underlying stock drops dramatically and you are now obligated to purchase the stock at extremely much higher price than it is currently trading.
Put selling is designed to complement a stock-trading portfolio because it offers two methods for generating profits: collecting premium by selling an Out-of-the-Money option and/or acquiring a stock at a reduced price.
This is an advanced strategy due to the potential large cash outlay an investor might have if a put he sold was exercised. There will be a margin requirement when selling puts. It is advised that you check with your broker for the requirements needed to implement this strategy.
Put selling takes advantage of the concept of time decay because the premium an option sells for declines as the option approaches expiration. This allows the options trader to profit without having to pick a perfect entry as in the case of trading stock or call options. Time will decay most rapidly the closer the option gets to its expiration.
Put selling is similar to the activity of an insurance company. Insurance companies collect premiums for accepting the contract to cover the risks of those they insure. You act like the insurance underwriter when you sell or short puts. As an underwriter, you would insure a person's car, home or businesses equipment in return for collecting the premium. If no claim is made against loss, then you keep the premium.
This is the crux of put writing or selling. In exchange for being paid a premium, you accept the downside risk of the underlying security. Insurance companies make billions of dollars annually because they know that you probably won't be crashing your car and they've spread their obligation over many different people. You can also be handsomely paid taking on those obligations in the stock market, provided that you take the necessary steps to limit your risk.
There is an argument as to whether this is a conservative strategy or speculation. The investor who is willing to purchase the underlying security and has the means to do so is not speculating. This investor has the capital necessary to purchase the stock and even though the assignment of the stock may not be what he planned, having the stock put to him is not necessarily a bad thing either.
Put selling becomes speculative when one sells puts and does not have the financial means to purchase the stock outright. He can do this because there is only an initial margin requirement for each short put (for margin purposes, a short put is considered uncovered regardless of the amount of capitol supporting the activity). This investor has the possibility of a bigger loss than he might be prepared to accept. This could be considered as speculation.

Some Things to Think About

There are two rules you must never ignore when selling puts:

• You should be bullish on the stock market in general.

• Only play fundamentally strong stocks that you are willing to purchase outright.

The greatest mistake a put seller can make is to sell puts on a stock that he or she is not willing to buy if the option is exercised.
You will need to meet the margin requirement in order to participate in put selling. It is advised that you contact your broker in order to determine the specific margin requirements.
Since you are selling a contract you want to get to expiration fairly rapidly and have time decay helping along. So, just like covered calls, you want to sell a short time frame, usually less than 30 days.

Let's review the guidelines one more time:

• Bullish on the general markets
• Fundamentally great stock
• Willing to buy it outright at the strike you sell
• Fulfill margin requirements
• Sell a short time frame

Let's look at some charts to discuss possible entries into this type of play. Sell the puts when the stock is in potentially low ranges of a bullish chart pattern.

The exit of this play depends on your mindset. You will either keep the premium or use it to purchase the stock at a lower price than it is currently trading. Your biggest concern with put selling is if the stock drops much more than anticipated. One of the dangers is that you are utilizing this strategy at the top of a raging bull market, the bubble pops and you in a sense actually catch the falling knife. Let's take a few moments to talk about how to manage this situation.

Risk Management

If the underlying security suddenly drops on bad news and you are concerned about it dropping further, you will need to purchase back an option with the same strike price and expiration that you sold. You will be taking a loss by doing this because if the stock has dropped, the put option has now increased in value. You can use the premium originally collected to help purchase back the option. It is not uncommon for the option to be exercised early in this scenario so you must act swiftly in order to cover yourself in case of this scenario.
One way to cut your risk is to do this on an Exchange Traded Fund (ETF), rather than expose yourself to the risk on an individual underlying security. If you have the ETF put to you, you will own a diversified investment and you can write covered calls on it.

A Form of Hedging

When we write and sell a CALL, we are using a form of hedging, it can be considered less risky and can offer some downside protection. We use this strategy to sell stock at a price we agree to or to generate income. We must own the underlying stock. If we do not, we will be uncovered or naked and exposed to high risk. This is not recommended for beginners.
When you are first starting out as an investor, your primary use of options should be as a form of hedging. The first strategy that you will most likely participate in will be covered call writing. Selling contracts allows for us to explore many alternatives to just buying stock and hopefully selling it at a higher price.
In contrast to taking on directional risk (buying puts and calls) where our entries and money management guidelines need to be very disciplined and clearly defined, hedging allows you to have some wiggle room as you gain experience in the markets.