Understanding the Basics of Options
Before diving into the world of options selling, let’s grasp the basics.
What are Options?
An option is a contract that provides the buyer with the right, but not the obligation, to buy (call option) or sell (put option) an underlying asset at a predetermined price (the strike price) within a specified time frame (until the expiry date). The fee paid for this right is called the premium.
The buyer of the option bets that the price of the asset will move in a particular direction, hoping to profit from this move. The seller, on the other hand, collects the premium and is obliged to fulfill the contract if the buyer chooses to exercise the option.
Using an example, let’s walk through a real-life example of a call option. Let’s say you’re in the market to buy a new home. You find an amazing house for sale at $300,000 and decide to purchase. You and your agent make an offer but include an option to cancel the purchase if the home fails an inspection.
This guarantees you the right to buy the home at $300k, but allows you five days to change your mind in case the home fails the home inspection. This is exactly the same as a call option, but instead of a home, we’re talking about stock.
How Do Options Work?
As mentioned before, there are two types of options: call options and put options.
Call Options
A call option is a contract that grants the buyer the right to purchase an underlying asset, such as a stock, bond, commodity, or any other financial instrument, at a predetermined price within a specified timeframe.
The predetermined price at which the asset can be bought is called the strike price, and the specified timeframe within which the purchase can be made is known as the expiration date.
For example, if you believed the price of Apple stock, currently at $200, will rise, you could buy a call option with a strike price of $205. Let’s say the price does rise, and moves up to $220, you could exercise your option, buying the stock at $205 and instantly selling it for $220, profiting from the difference.
Put Options
A put option is a contractual agreement that gives the holder the right, but not the obligation, to sell an underlying asset at a predetermined price, called the ‘strike price’, within a specified timeframe. The assets in question could be stocks, bonds, commodities, or other financial instruments.
Using a real-life example, let’s say you own a house valued at $500,000 and are looking to purchase some home insurance. This guarantees your house is protected in the event a disaster happens.
In terms of the stock market, the house is the stock, the insurance policy is the put option, and the premium is the price you pay for the put option. If the stock price goes down, you can exercise your put option and sell the stock at the higher strike price, thereby protecting against significant losses. If the stock price stays the same or rises, your put option would expire worthless, and the premium you paid would be your loss.
Common Options Terminology
Options trading comes with its own unique language. We’ve already touched on a few, but here are some terms you’ll want to remember:
- Premium: This is the cost of an options contract. The buyer pays this amount upfront to the seller. It’s the price of obtaining the rights granted by the options contract.
- In the Money (ITM): This refers to an options contract that has intrinsic value. For a call option, it means the underlying asset’s market price is above the strike price. For a put option, it means the market price is below the strike price.
- At the Money (ATM): An options contract is ATM when the market price of the underlying asset equals the strike price.
- Out of the Money (OTM): This refers to options contracts that are entirely composed of time value. A call option is OTM when the market price is below the strike price, while a put option is OTM when the market price is above the strike price.
- Option Chain: This is a listing of all available options contracts for a security, showing all puts, calls, strike prices, and pricing information for each contract.
- Option Writer: The individual or institution that creates a new options contract and guarantees the trade. The writer is obligated to meet the terms of delivery if the owner exercises the contract.
Why Sell Options?
Selling options, also known as writing options, might initially seem counterintuitive, especially if you’re new to the world of options trading. After all, why sell something that potentially has unlimited risk?
1. Consistent Income Generation
One of the primary reasons for selling options is the consistent income it can generate. The premium received from selling an options contract can provide a steady cash flow.
This is especially true for selling out-of-the-money options, where the chance of the option being exercised is lower, and the seller can often retain the premium.
2. Higher Probability of Profit
When you sell an option, there are more ways to make a profit than when buying an option. When selling, you can profit if the price stays the same, moves against you slightly, or moves in your favor.
When buying, you generally only profit if the price moves in your favor and by enough to cover the premium you paid.
3. Hedging Risk
Options selling can also serve as an effective hedging strategy. For example, if you own a stock and sell a covered call (an option on a stock you own), you can use the premium received to offset potential losses if the stock’s price declines.
Essentially, you’re being paid to limit your upside on a stock in return for some downside protection.
4. Utilizing Time Decay
Options contracts have a finite lifespan, and their value decreases over time, a phenomenon known as time decay or “theta.” As an options seller, you can use this to your advantage and profit from the decay.
If all other factors remain constant, the value of the option you sold will decrease over time, increasing your chances of closing the trade profitably.
Options Selling Strategies
Options selling can offer consistent income and hedge against other investments. However, the type of strategy used can greatly affect risk and return. Let’s delve into five popular options selling strategies, their risk/reward profiles, thought processes behind them, and examples.
Covered Calls
Covered calls involve selling a call option on a stock you already own.
The risk lies in limiting the upside potential of your stocks since you must sell your stocks at the strike price if the option is exercised. However, the reward comes in the form of the premium received and any appreciation of the stock up to the strike price.
Covered calls are typically employed when you have a neutral to slightly bullish outlook on the stock. You’re willing to forego some potential upside for the immediate income from the premium.
For example, say you own 100 shares of XYZ stock, which is currently trading at $50. You could sell a covered call with a strike price of $55, earning a premium. Let’s say the total premium received was $5.00.
If the stock price stays under $55, you keep the premium. If the stock price rises above $55, you must sell your shares at $55 each but still keep the premium.
Cash-Secured Puts
Cash-secured puts involve selling a put option while keeping enough cash to buy the stock if the option is exercised.
The risk lies in the potential for the stock to drop significantly below the strike price, but the premium received and the ability to buy the stock at a lower price are the rewards.
This strategy is used when you have a neutral to slightly bearish outlook on the stock and wouldn’t mind owning the stock if the price falls.
For example, suppose XYZ stock is trading at $50. You could sell a cash-secured put with a strike price of $45 and earn a premium. Like the previous example, you receive $5.00 in credit when selling the put.
If the stock price stays above $45, you keep the premium. If the stock price falls below $45, you must buy the stock at $45 per share, but you still keep the premium.
Short Vertical Spreads
Also known as credit spreads, these involve selling one option and buying another option of the same type (call or put) but at a different strike price.
The risk in this strategy is limited to the difference between the two strike prices, less the premium received. The reward is the premium received.
Traders use this strategy when they expect the price of the underlying asset to remain the same with a slightly bullish or bearish bias.
For example, let’s assume XYZ stock is trading at $50. You believe the stock is likely to remain the same or potentially decline over the next few weeks. To capitalize on this, you decide to sell a $55 call option and buy a $60 call option, receiving a net premium of $2.00.
If the stock price stays under $55, you keep the entire premium. If the stock price rises above $55, your loss is limited to the difference between the two strike prices, less the premium received.
Iron Condors
An iron condor strategy involves selling a call spread and a put spread on the same underlying asset with the same expiration date.
The maximum risk is the difference between the strike prices of the spreads less the net premium received. The maximum reward is the net premium received.
Traders use this strategy when they expect the price of the underlying asset to stay within a specific range.
For example, let’s assume XYZ stock is still trading at $50. Based on market trends, you believe the stock is going to remain trading in a tight range over the next few weeks. Based on that, you decide to sell a $45/$40 put spread and a $55/$60 call spread, receiving a net credit of $3.00.
If the stock price stays between $45 and $55, you keep the entire premium. However, if the stock price rises above $60 or falls below $40, your loss is limited to the difference between the strike prices of the spread, minus the credit received.
Iron Butterflies
This strategy involves selling an at-the-money call and put and buying an out-of-the-money call and put.
The maximum risk is the difference between the strike prices less the net premium received. The maximum reward is the net premium received.
Traders use this strategy when they believe the price of the underlying stock is likely to stay the same. It’s essentially an Iron Condor, but with the short options sharing a common strike.
For example, XYZ stock is still trading at $50. Since you believe it’ll remain at $50 for the foreseeable future, you could sell a $50 call and put – then buy a $50 call and $40 put, receiving a net credit of $5.00.
If the stock price remains at exactly $50, you keep the entire premium. If the stock rises above $55 or falls below $45, you would take the max loss on the spread. Realistically, you’re never trying to get the max profit when trading Iron Flies. Many decide to close around 20% – 30% profit.
Risks and Rewards
The prospect of generating regular income through selling options is enticing, but like any investment strategy, it comes with a unique blend of risks and rewards. Let’s delve into both aspects to help you understand what you’re getting into.
Risks of Selling Options
- Unlimited Risk Potential: Selling naked or uncovered options carries an unlimited risk potential. This is especially true for call options where if the underlying asset’s price soars, you are obliged to sell the asset to the option buyer at the significantly lower strike price. This can result in substantial losses.
- Potential for Large Losses: Even when selling covered options or cash-secured puts, while your risk is capped, you can still suffer significant losses. If the market moves dramatically against your position, the asset’s price can fall below your cost basis.
- Requirement for Collateral: When you sell an option, you’re obligated to fulfill your end of the contract if the buyer chooses to exercise. This requires you to maintain collateral in your account, which can tie up a significant portion of your investment capital.
- Early Assignment Risk: Particularly with American-style options, the option buyer can choose to exercise their option at any point before expiration, which may not always be advantageous for the seller.
Rewards of Selling Options
- Premium Income: One of the major appeals of options selling is the premium income you receive upfront. This income can be used as a hedge against other investments, added to your overall returns, or even used to buy other assets.
- Downside Protection: Selling options can provide some level of protection against small declines in your portfolio. The premium you receive can offset some of the losses if the underlying asset’s price decreases.
- Potential for Profit in Different Market Conditions: Certain options strategies can generate a profit whether the market is moving up, down, or sideways. For instance, neutral strategies like selling iron condors or covered calls can still yield profits in a stagnant market.
- Increased Portfolio Yield: Regularly selling options against your holdings (covered calls) can increase your overall portfolio yield over time by generating consistent income.
