With stocks getting pummeled on a daily basis, and the market wringing its hands at every turn of events, investors might believe it wise to start selling options to profit from the uncertainty.
There may be gold in them thar calls, but these days there's no such thing as easy money. We've done up a quick primer on selling options that can be a good first step into the pool.
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Considering the chronic swings in the stock market lately, the implied volatility of stocks --particularly those of the technology strain -- has risen sharply and made selling expensive options seem like a golden opportunity.
Sometimes, though, the temptation is better off resisted.
An investor can sell either an equity put or call option contract to open a position (in options, you don't have to own something to sell it). The seller of the option contract also is referred to as an option writer. Simply said, investors sell options to collect the contract's premium against the chance that the stock will move toward the strike price, making the option more valuable.
If you sell an option without owning the underlying shares, that would be referred to as a naked option, and while typically that sounds appealing, investors taking such positions have spilled a considerable amount of blood in the past.
The first thing to remember is that selling an option brings with it an obligation. A call buyer pays for the right to
the stock at the strike price; a call seller gets paid for the obligation to
the stock at the strike price if the call is exercised.
While a put buyer pays for the right to
a stock at a fixed price by a certain time, a put seller gets paid for the obligation to
the stock at that time.
When you sell either, the market will say you are short the options. That doesn't mean, however, that you are short the stock. If you sell a put, it means you've decided you'd be willing to own a stock at a certain price, and that's essentially a long position.
Volatility and You
Among the components of the price of any option contract is implied volatility, the annualized measure of how much the market believes a stock or index can potentially move, and it is a critical factor in an option's price. When volatility is high, the option's price will be high.
Here's an example: An investor sells a call option contract on ZZZ (a fictitious ticker symbol), whose strike price is 50, and the option expires in June. ZZZ is trading at, let's say, 48. The investor sells the contract in the market for $3, collecting $300 (the $3 is multiplied by 100, because each option contract represents 100 shares of stock).
In that example, the most an investor could make for selling the call option is $300. If the call option expires worthless, meaning ZZZ doesn't get to 50 or above, the investor will have made $300. And because the option expired worthless, he or she doesn't have to supply the stock to the call buyer because the option won't be exercised.
The problem with option selling -- of either put or call options -- is that there is the potential for huge losses. In the above example, say ZZZ rises above 50 and is in the money; the losses could be huge for the call seller, particularly if the call seller doesn't have the stock on hand to deliver to the person exercising the option.
If the call option is exercised at 57, the most the seller of the call option would lose would be $400, because the investor would collect $5,000 for the stock he or she was delivering from the person buying the option contract and the call writer would still have the $300 premium.
Selling puts can be even more hair-raising. If you were to sell a ZZZ put at 50 with the stock at 55, you would be forced to buy the stock at 50, even if it were in the midst of a death spiral down to 40. How's that for easy money?
That's the rub for selling options. Investors often mistake selling calls, for instance, as protection, or selling puts as a cheap way to get long. Neither should be leaned on too heavily; selling options are best used to express neutrality during a period when you're not expecting dramatic movement.
The problem is that premiums often don't seem big enough during those periods to be worth the risk.
As originally published, this story contained an error. Please see
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