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.
- Selling options can be a consistent way to generate excess income for a trader, but writing naked options can also be extremely risky if the market moves against you.
- Writing naked calls or puts can return the entire premium collected by the seller of the option, but only if the contract expires worthless.
- Covered call writing is another options selling strategy that involves selling options against an existing long position.
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 higher risk 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 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.
When Should I Sell A Put Option Vs A Call Option?
An investor would choose to sell a naked 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.
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.
An investor would choose to sell a naked 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.
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 his or her 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 also come 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 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.