An option is a contract written by a seller that conveys to the buyer the right -- or option -- to buy or sell a certain asset, such as shares of stock or some other type of financial instrument, at a certain price. Selling options is an interesting aspect of securities trading that investors should become familiar with to maximize their profits. The strategy of selling options has become increasingly popular with traders who have learned how to manage the risk inherent in options transactions.
For most traders and investors, the most difficult part of their day is deciding where they think markets are headed, and when. However, when selling options, a trader doesn’t have to predict where the market will go, but rather where it will not go. He selects a price level that he believes a stock will not reach in the near future, and sells an option for this price point. The option acts as something of an insurance policy against unexpected price moves for the person who buys one.
There are two types of options that are commonly bought and sold. The first type is a covered option, which means that the seller of the option owns the underlying stock or asset. The second type is a naked option, where the seller does not own the underlying asset and is most likely speculating on the direction the stock will move, rather than attempting to hedge risk. In a side-by-side comparison, covered options are the safest, although in practice many options sellers use more naked options because of the expense involved in first purchasing the stock.
An options transaction might proceed as follows. In February, an investor owns 1000 shares of XYZ stock, which trades at $100 U.S. Dollars (USD) a share. An investor feels that over the next month, shares of XYZ will not be worth more than $105 USD. In this case, the investor would sell an option contract for XYZ stock at $105 USD to another investor who feels differently. If a contract for XYZ stock in March at $105 USD sells for $5 a share, the option seller will receive $5,000 USD in total, up front, for that option.
In theory, the stock price may move in any direction from the $100 USD price point, but if the stock increases in value to less than $105 USD per share, the option writer makes additional money. The option in the above example is called a “call” option, because the seller believes the price will not go up, and a “put” option is one sold by someone who believes the price will not go down.
The strategy of selling options makes good sense for many investors, especially in light of the estimation by the Chicago Mercantile Exchange (CME) that approximately 80% of options held through their expiration date expire worthless. Especially in times of market volatility, many investors feel that they would like this statistic on their side. In learning about selling options, there are many important considerations, and options trading carries levels of risk that may not be acceptable to everyone.