The incorporation of options into all types of investment strategies has quickly grown in popularity among individual investors. For beginner traders, one of the main questions that arises is why traders would wish to sell options rather than to buy them. The selling of options confuses many investors because the obligations, risks, and payoffs involved are different from those of the standard long option.
To understand why an investor would choose to sell an option, you must first understand what type of option it is that he or she is selling, and what kind of payoff he or she is expecting to make when the price of the underlying asset moves in the desired direction.
Selling a put option - An investor would choose to sell a put option if her outlook on the underlying security was that it was going to rise, as opposed to a put buyer whose outlook is bearish. The purchaser of a put option pays a premium to the writer (seller) for the right to sell the shares at an agreed upon price in the event that the price heads lower. If the price hikes above the strike price, the buyer would not exercise the put option since it would be more profitable to sell at the higher price on the market. Since the premium would be kept by the seller if the price closed above the agreed upon strike price, it is easy to see why an investor would choose to use this type of strategy.
When Should I Sell A Put Option Vs A Call Option?
Let's look at a put option on Microsoft (MSFT). The writer or seller of MSFT Jan18 67.50 Put will receive a $7.50 premium fee from a put buyer. If MSFT's market price is higher than the strike price of $67.50 by January 18, 2018, the put buyer will choose not to exercise his right to sell at $67.50 since he can sell at a higher price on the market. The buyer's maximum loss is therefore, the premium paid of $7.50, which is the seller's payoff. If the market price falls below the strike price, the put seller is obligated to buy MSFT shares from the put buyer at the higher strike price since the put buyer will exercise his right to sell at $67.50.
Selling a call option without owning the underlying asset - An investor would choose to sell a call option if his outlook on a specific asset was that it was going to fall, as opposed to the bullish outlook of a call buyer. The purchaser of a call option pays a premium to the writer for the right to buy the underlying at an agreed upon price in the event that the price of the asset is above the strike price. In this case, the option seller would get to keep the premium if the price closed below the strike price.
The seller of MSFT Jan18 70.00 Call will receive a premium of $6.20 from the call buyer. In the event that the market price of MSFT drops below $70.00, the buyer will not exercise the call option and the seller's payoff will be $6.20. If MSFT's market price rises above $70.00, however, the call seller is obligated to sell MSFT shares to the call buyer at the lower strike price, since it is likely that the call buyer will exercise his option to buy the shares at $70.00.
Another reason why investors may sell options is to incorporate them into other types of option strategies. For example, if an investor wishes to sell out of his or her position in a stock when the price rises above a certain level, he or she can incorporate what is known as a covered call strategy. Many advanced options strategies such as iron condor, bull call spread, bull put spread, and iron butterfly will likely require an investor to sell options.