By Mike Tibbits, YouCanTrade Content Specialist
Understand the risks of being an options seller
There are two ways to sell options both with their own risks. You can either sell call options or sell put options. Before you sell either one, you should be aware of assignment. Being assigned means you must meet the deliverable terms of the option contract. For calls, when you sell a call, if you are assigned, it means you are obligated to sell shares to the buyer at the strike price. For puts, when you sell a put, if you are assigned, it means you are obligated to buy the shares from the option buyer.
Key Takeaway: Selling options is risky, but that’s why you are paid a premium for taking on such risks. If this is too risky for you, then don’t sell options.
Look at implied volatility
Implied volatility is the measurement of the perceived risk for a particular option contract – the risk being the uncertainty of where the market could go. During periods of high implied volatility, or uncertainty, options prices tend to be higher than normal. A popular example of high implied volatility is an expected news event, such as a quarterly earnings report. Options prices are inflated due to the large and sudden movements that often accompany the underlying stock price when the earnings reports are released. Once the events are known, implied volatility usually drops and brings the value of the option down along with it. Many options sellers take advantage of this and sell options during periods of high volatility to collect more credit.
Key Takeaway: During periods of high volatility, options premiums tend to be inflated.
The impact of time
Other risk factors can also affect an options pricing. Another is time. Time has a detrimental effect on an option’s premium, which is known as time decay. Options with more time until expiration are more expensive than those about to expire because they provide more risk to the options seller. As the expiration day for an option approaches, the negative effects of time decay increase exponentially until the price of the option is reduced to the difference between the strike price and the underlying stock price, or even zero in some cases.
Key Takeaway: Selling options takes advantage of time decay, which makes the option cheaper to buy back later. Of course, this also implies that the stock price didn’t change much during the time you sold the option.
Common options strategies
Let’s review two strategies for selling options.
Example #1: Selling Covered Calls
You buy 100 shares of a stock you like and then sell one call at a strike price higher than you paid for the shares of stock. Selling the call will allow you to collect a credit from the options buyer. If the stock closes above the strike price on expiration day, or if you get assigned, you must sell your stock at the strike price to whoever holds the contract. If the stock price is not above the call strike that you sold, then you keep the credit you collected for selling the call and you keep your shares. You can do this until your shares are called away by assignment.
Example #2: Selling Naked Puts to Buy a Large Stock Position
Let’s say you see stock that you believe is undervalued and it’s trading at a very attractive price point. Assuming you would not mind buying 100 shares of that stock at that price, you could sell a put option at the strike price nearest to where the stock is trading, also known as an at-the-money put.
Selling the put would obligate you to purchase the 100 shares of the underlying stock at the strike price, if assigned. If the stock closes above the strike price by expiration, you get to keep 100% of the monies you collected for selling the put. If, on expiration day, the stock closes below your strike price, congratulations, you have purchased 100 shares of stock at the price you wanted, and you keep 100% of the monies for selling the put option.
If you sell options, you need to be aware of the risks you are taking on. Volatility and time decay can impact your position, your risk and your reward. Carefully think through your trade plan and consider all the variables.