Investors may choose to sell options as part of their investment strategy, and the timing of these sales will depend on two factors: whether the option is a put or call option, and whether they expect the price of that asset to rise or fall. Traders would sell a put option if their outlook on the underlying was bullish, and would sell a call option if their outlook on a specific asset was bearish.
The selling of options involved very different obligations, risks, and payoffs than traders take on with a standard long option. As a result, this is a risky strategy that should only by used by experienced traders.
Key Takeaways
- A call option gives a trader the right to buy the asset, while a put option gives traders the right to sell the underlying asset.
- Traders would sell a put option if they are bullish on the asset's price and sell a call option if they are bearish on the price.
- "Writing" refers to selling an option, and "naked" refers to strategies in which the underlying securityis not owned and options are written against this phantom securityposition.
- Selling options can be a consistent way to generate excess income for a trader, but writing naked options can be extremely risky if the market moves against you.
- Covered call writing is another options selling strategy that involves selling options against an existing long position.
Call vs. Put
A call option gives a trader the right to buy the asset underlying the option. Traders purchase call options if they expect that the price of the asset is going to rise. A put option, on the other hand, gives traders the right to sell the underlying asset. Traders buy put options if they expect that the price of the asset is going to decline.
Traders sell call options and put options in the opposite direction. That is, a trader would sell a put option if they are bullish on the price of the underlying asset. They would sell a call option if they are bearish on the asset price.
Options Terminology: Writing and Naked
In options terminology, "writing" is the same as selling an option. "Naked" refers to strategies in which the underlying securityis not owned and options are written against this phantom securityposition. The naked strategy is aggressive and highly risky, however, highly experienced investors can use it to generate income as part of a diversified portfolio
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 Put Options
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.
:max_bytes(150000):strip_icc()/Clipboard01-617b9d39bcc744d691fc612f569587e0.jpg "Put Option vs. Call Option: When to Sell (1)")
Example
Let's imagine an asset XYZ. The writer or seller of XYZ Oct. 18 67.50 Put will receive a $7.50 premium fee from a put buyer. If XYZ's market price is higher than the strike price of $67.50 by Oct. 18, 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 XYZ shares from the put buyer at the higher strike price since the put buyer will exercise their right to sell at $67.50.
Selling Call Options
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.
:max_bytes(150000):strip_icc()/NakedCallWriting-AHighRiskOptionsStrategy2_2-aab223af50cc44ba9a0f874609356225.png "Put Option vs. Call Option: When to Sell (2)")
Example
The seller of XYZ Oct. 18 70.00 Call will receive a premium of $6.20 from the call buyer. If the market price of XYZ drops below $70.00, the buyer will not exercise the call option and the seller's payoff will be $6.20. If XYZ's market price rises above $70.00, however, the call seller is obligated to sell XYZ 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.
A naked call position, ifnot used properly, can have disastrous consequences since the price of a securitycan theoretically rise to infinity. The potential profit is limited to the price of the option's premium. This high potential loss compared to a limited potential gain is what makes this strategy so risky.
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 along positionin anassetthen 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.
:max_bytes(150000):strip_icc()/CoveredCall-943af7ec4a354a05aaeaac1d494e160a.png "Put Option vs. Call Option: When to Sell (3)")
What Are the Risks of Selling Options?
Selling options can be risky when the market moves adversely. Selling a call option has the potential risk of the stock rising indefinitely. When selling a put, however, the risk comes with the stock falling, meaning that the put seller receives the premium and is obligated to buy the stock if its price falls below the put's strike price. Traders selling both puts and calls should have an exit strategy or hedge in place to protect against loss.
When Should You Sell a Call Option?
An investor would choose to sell a call option if their outlook on a specific asset was that it was going to fall.
When Should You Sell a Put Option?
An investor would choose to sell a put option if their outlook on the underlying security was that it was going to rise.
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 options 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.
