In contrast to buying options, an options seller trader sells stock options. This comes with an obligation to sell the underlying equity to a buyer if that buyer decides to exercise the option and the trader is "assigned" the exercise obligation. "Selling" options is often referred to as "writing" options.
When options seller traders sell (or "writes") a Call- they are selling a buyer the right to purchase stock from them at a specified strike price for a specific period of time, regardless of how high the market price of the stock may climb.
There are two styles or methods of writing options:
Covered Calls - The option sellers own the underlying stock that the option is derived from. In a covered call, they are selling the right to buy an equity that they own.
With covered call options they already own the stock, hence the term "covered." They need to own at least 100 shares of stock to sell a covered call, because 1 stock option equals, represents, or controls 100 shares of stock.
If buyers decide to exercise their option to buy the underlying equity, the options seller trader is obligated to sell to them at the strike price - whether the strike price is higher or lower than their original cost of 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."
Example: If options seller traders buy 100 shares of an ETF (exchange-traded fund) at $20, and immediately write one covered call option at a strike price of $25 for a premium of $2, they immediately take in $200 - the premium.
There are generally three things that can happen now that the options seller has sold this covered call:
- The option the traders sold will expire worthless, which just means that the person never exercised their right to buy the stock. In most cases, this is what they want to happen because they would have made some easy money.
So, if the ETF's market price stays under $25, then the buyer’s option will expire worthless, and they have gained the $200 premium.
- The options seller trader is "called out." This is the term they use when the buyer of the option decides to exercise their rights and buys the stock. Since the options seller sold the covered call option, they are obligated to deliver those shares to the buyer.
In this instance, the ETF's price rises above $25, which means that the options seller may have to sell their ETF and will lose its upside appreciation above $25 per share.
- The stock price drops dramatically and the options sellers start to panic because they can't sell the shares. Once they sell a covered call, those shares are now obligated. The options seller can't do anything with those shares as long as that covered call is still an open trade. One way out of this situation is to buy the option back, which then frees up those shares and at this point the trader could sell the stock.
This means that the options seller can close out the position by buying an option on the same ETF with the same strike price and expiration in a closing transaction to at least partially reduce a potential loss.
Naked or Uncovered Calls - The option seller does not own the underlying stock that the option is derived from. They would be selling the rights to something that they don't own. Naked option selling has significant risk and is not recommended for novice traders.
Options sellers who engage in naked option selling often utilize a strategy using “options greeks.” Selling naked stock options is the riskiest, but also the most profitable form of option selling. In theory, they just sit back and sell stock options and collect money month in and month out. They never have to worry about tying up a lot of cash to buy the stock.
Example: An options seller trader writes a Call on a stock for a premium of $2, with a current market price of $20, and a strike price of $25. Again, they immediately take in $200 - the premium.
- If the stock price stays under $25, then the buyer’s option expires worthless, and the seller has gained $200 premium.
- If the stock price rises to $30 and the option is exercised, they will have to buy 100 shares of the stock at the $30 market price to meet their obligation to sell it at $25. They lose $300 - the difference between their total $3,000 purchase cost for the stock, minus their proceeds of $2,500 from the sale of exercised stock and the $200 premium they took in for selling the option.
As this example demonstrates, uncovered Call writing carries substantial risk if the equity’s price increases sharply.
Selling put options
Obviously, if options seller traders sell calls, they would also be in the market for selling puts. Put option writers, also known as sellers, sell put options with the hope that they expire worthless so that they can pocket the premiums. Selling puts, or put writing, involves more risk but can be profitable if done properly.
- Covered Puts - The written put option is covered if the put option seller is also short the obligated quantity of the underlying security. The covered put writing strategy is employed when the investor is bearish on the underlying. ·
- Naked Puts - The short put is naked if the put option seller did not short the obligated quantity of the underlying security when the put option is sold. The naked put writing strategy is used when the investor is bullish on the underlying. For the patient investor who is bullish on a particular company for the long haul, writing naked puts can also be a great strategy to acquire stocks at a discount.
Rules for selling
Selling options is best done when implied volatilities, and therefore option premiums, are high and expected to fall. This is because higher implied volatility brings in more premium income to the trader’s account. It is important to remember, however, that selling options involves considerable risk, and high implied volatility can always go higher.
As we already know, time decay is greatest in the last 30 to 45 days; this is typically the best time to sell options. It is ideal for the options seller trader to have the options expire worthless, and in most cases the trader is not interested in buying back the options they have sold, unless necessary.
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