Put Option vs. Call Option: When to Sell

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 arise 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.

Overview

In options terminology, "writing" is the same as selling an option, and "naked" refers to strategies in which the underlying security is not owned and options are written against this phantom security position. The naked strategy is aggressive and highly risky but can be used to generate income as part of a diversified portfolio. However, if not used properly, a naked call position can have disastrous consequences since a security can theoretically rise to infinity. 

To understand why an investor would choose to sell an option, you must first understand what type of option they are selling, and what kind of payoff they are expecting to make when the price of the underlying asset moves in the desired direction.

Selling Puts

An investor would choose to sell a naked put option if their 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 a 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. 

Example

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 Jan. 18, 2018, the put buyer will choose not to exercise their right to sell at $67.50 since they 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 their right to sell at $67.50.

Selling Calls

An investor would choose to sell a naked call option if their 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.

Example

The seller of MSFT Jan. 18 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 their option to buy the shares at $70.00.

Writing Covered Calls

A covered call refers to selling call options, but not naked. Instead, the call writer already owns the equivalent amount of the underlying security in their portfolio. To execute a covered call, an investor holding a long position in an asset then sells call options on that same asset to generate an income stream.

The investor's long position in the asset is the "cover" because it means the seller can deliver the shares if the buyer of the call option chooses to exercise. If the investor simultaneously buys stock and writes call options against that stock position, it is known as a "buy-write" transaction.

Covered call strategies can be useful for generating profits in flat markets and, in some scenarios, they can provide higher returns with lower risk than their underlying investments

The Bottom Line

Selling options can be an income-generating strategy, but it also comes with potentially unlimited risk if the underlying moves against your bet significantly. Therefore, selling naked options should only be done with extreme caution.

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 their position in a stock when the price rises above a certain level, they 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.