Option Trading Strategies-Selling Options

The Easiest Money And The Dumbest Trade I Ever Made

Here at stock options explained we have covered options trading strategies such as simply buying stock options and also selling options, with the idea that stock options basics could best be conveyed from the standpoint of actual examples behind trading strategies, rather than simply limiting our discussion to theoretical ideas. At any rate, in this vein I thought it might be of interest and helpful to illustrate option trading strategies from a real-life example that’s of particular interest to me. I’ll show how selling options involves more than the risk of having your options exercised so that your stock is called away from you (if you’ve written calls) as it rises well beyond the strike price and you miss out on further gains beyond the strike price. There is an additional danger, one not related to opportunity cost.

In this type of trade, while you will receive some protection from selling options because of the reduced cost basis for your stock (as you receive a premium amount from the option buyer), this lower cost basis might be no match for the amount by which the underlying stock could fall. In other words, using this trading strategy one may sell covered calls against stock he owns and get to keep the premium if those calls expire worthless, but still take a much larger hit because of a drop in the stock price. You might think you’re buying some protection after a run-up, but the market might have much bigger plans!

I would like to illustrate selling options in this context not with call options, but with a trade involving put options. I had a front row seat on this particular trade, as it was I who was doing the trading! The mechanics with selling puts are the same as with selling calls, though your directional preference is reversed with puts. One can write covered, out of the money puts as a way to insure a short position, hoping that the worst that will happen is a drop below the strike price, below which he no longer benefits at expiry as he must cover his short position at the strike. If a trader employs fairly complex option trading strategies of this kind is also fully aware that the stock price could rise, which could easily outweigh that put premium amount that he receives for writing his covered puts. I said “he” but I might just as well have said “I”. Well, here we go.

Flash Crash!

If you were anywhere near planet Earth during the week ending May 7, 2010, you might remember how quickly the market dropped from above 1200 on the S&P 500 down to a low on the day of the “flash crash” (May 6) of 1056. The market bounced off the flash crash lows, closing the day out at 1128, but the next day, Friday, May 7 was also ugly, with the S&P 500 closing that day at 1110. The reason I remember the events so clearly is that I sold put options a few minutes before the close of trading on that Friday, a move that I have thought of ever since as both the easiest money and possibly the dumbest trade I ever made.

I’ll elaborate a little. For once in my life I had made a correct move and was short SPY from above 120. SPY is a heavily-traded ETF based on the S&P 500, and is a convenient proxy for the overall market. The VIX (a popular volatility indicator) was low and the markets, though they had been grinding higher for months, seemed to me to be ripe for a fall. I decided not to use options for leverage, so I could wait. Well, like everyone else I was stunned by the events of Thursday, May 6, when the Dow Jones Industrial Average fell almost 1000 points. I remember watching CNBC, which had a live feed from Athens, Greece, where there were real tensions over austerity measures imposed by the Greek government. As things appear to start to get out of control there on the streets of Athens, action in the markets worldwide seem to mirror the possibility of real calamity. Even though I was short, the speed of the events unfolding left me utterly flat-footed vis-à-vis my position, and while someone with a clearer head might have chosen to cover his short position when the market was down over 10% in just one day, I did not do so.

The next day I watched again as the bounce that the whole world seemed to be hoping for after the chaos of the “flash crash” did not occur. That Friday was nowhere near as ugly as the previous day but the market was again down nearly 4% intraday.

As the market neared the close on Friday I remember my thought process very clearly: while the market was clearly very oversold it seemed that the upward trend had broken so violently that we were headed dramatically downward again over the next few weeks. Still, with the volatility so high at that moment options premiums were extremely inflated, especially for put options. What this means is that if one were to write put options against an existing short position one would receive, relatively speaking, a very large premium amount simply for promising to buy back shares-or cover his short position-at lower levels, even much lower. One way to look at is is that you could be paid for profiting even further from your short position. Now, there are legitimate option trading strategies for every market situation, and at a time like this capturing volatility is often smart, because even if the market continues down at a slower rate (or stays even) one could see a reduction in the component of the premium that had been inflated due to the volatility (if we are talking out of the money options, that would be 100% of the premium, of course).

On this particular day I was able to sell five SPY May 100 puts against the 500 shares of SPY that I was short, for 1.05. SPY was just a hair over 110 when I wrote these puts, so that means that with only ten trading days left before expiration that SPY would have to go down a full ten points for them to be in the money. After that terrible week it seemed very unlikely that it could happen so quickly, but I told myself that if the overall market experienced another 10% decline during those two weeks I’d be happy to get 20 points on the SPY out of the trade that fast (I was already ten SPY points lower than my entry, remember). The approximately $500 I received from selling options to a trader or traders who were willing to bet $100 per contract that SPY would be over ten points lower in ten days (just to reach the strike price), seemed like the easiest money I’d ever made. Hopefully the puts would expire out of the money, worthless, I would keep the premium and then in the next several weeks I’d eventually see SPY below 100, maybe much lower, with me looking great on my still-intact short position.

Well of course anything might have happened, but what did happen was that the market bounced on the open Monday and into the earlier part of the week. When I covered my short position several points higher I got to keep almost all of the $500 I’d received in premium for selling the puts (yay!). However, my gains from my short position were a few thousand dollars less than what they might have been had I simply covered my short on the preceding Friday, rather than fixating on how likely it was that I’d keep most of the premium!

I don’t fault myself for not being clairvoyant, and I think that the only mistake I really made selling options here was overemphasizing the likelihood that I would keep most or all of the put premiums, relative to the possibility that a violent snapback could occur and quickly negate that $500 position. Still, both trades were profitable, and my actions were in line with the old adage “cut your losses and let your profits run”. Well, they also say that no one ever went broke taking a profit, and might have been was a large one! Maybe I have overemphasized how silly I feel not simply taking a huge, quick profit (heck, I’m sure I’ve made dumber trades) but in any case, for purposes of getting option trading strategies explained to readers of this site, I think this anecdote has value.

Options Trading Strategies-Two Basic Ways To Play

If you’re trying to understand option trading strategies, and terms like strike price, expiration date, time decay, and covered and uncovered calls and puts, there’s a basic understanding that you should have, an overview of stock options basics in terms of two diametrically opposed strategies, that will help you understand both buying options and selling options (aka writing options). As the scope of this site has expanded, I’ve seen that the best way for new investors to have stock options explained to them is from the perspective of option trading strategies rather than simply theoretical articles about options basics.

If you’re familiar with options only as a trading vehicle that some investors use to attempt to make huge gains very quickly, you probably have wondered what terms like “writing calls” and “naked puts” are all about. The fact is that the risky buy-side trades with which new investors are most familiar is just the tip of the iceberg when it comes to the range of ways one can use stock options to maximize the performance of their overall portfolio.

Every options transaction has a seller on the other side of the transaction from the option buyer. This makes intuitive sense, but maybe you have assumed that the option seller is an options exchange or even some large broker. This is incorrect. The fact is that anyone can sell puts and calls just as they can buy them (pending approval from your broker, who will want you to attest that you understand options well enough to approve you for trading them in the first place).

But why would I sell options, rather than buying them? The difference lies in the motivation underlying both sides of the trade. I’ll explain call options here.

Whereas the buyer of the right to buy 100 shares of stock at a given price by a given date in the future is looking for a method to leverage a relatively small amount of money for the possibility of a large percentage gain, the seller of that right is most often looking for a way to protect long stock positions that he already has in his portfolio. There is an exception to this, in the form of very risky sell-side option trading strategies known as uncovered or “naked” call or put selling, but I’ll save that stock options explanation for the end of this article to avoid confusion.

Essentially the option seller is selling the right to purchase shares that he owns at a “strike price” that he would be happy receiving for his shares, should they reach that price. Normally the seller will pick a strike price higher than where the stock is currently trading. In return, the option contract seller or writer receives a premium amount from the option buyer.

For example, if I own 1000 shares of IBM and the stock is at 140, I can sell ten option contracts of IBM 160 calls, and I will receive an amount of money from the buyer or buyers of these 10 contracts. How much money depends on how far away the expiration date is, the volatility of the stock and other factors. Should IBM be trading over 160 by the expiration date, my stock will be called away from me i.e. I will be obligated to deliver it to the buyers of the options in return for the premium that they paid me. Note that I am still happy because I experienced appreciation between the 140 level and 160, plus the premium payment, although if IBM rises to say, $200 per share before expiration I will most likely regret selling calls against my shares in the first place!

If IBM falls or at least stays below 160 strike price between the day I initiate the trade and the expiration date, then the options will expire “out of the money”, worthless. That means that I no longer have the possibility of having to deliver my shares; the transaction is concluded at the expiration date. If I’m the option seller I keep one hundred percent of the premium amount, minus commissions, and unfortunately the option buyer loses whatever he paid to enter the transaction. Regardless of where the stock price is at expiration in this situation, my cost basis for my shares has been lowered by the amount of premium that I received.

In this example the call buyer is bullish (i.e. optimistic) on the stock and the call seller is bearish, or at least not overly bullish (after all he’s not bearish enough to sell his shares). It might have occurred to you that just as a put buyer is bearish on a stock that the put seller must be bullish (or at least not excessively bearish). This is an accurate assumption. This implies that ultimately one can’t think of either buying or selling options as bullish or bearish trades, as you could be a call buyer or put seller if you were bullish-to-neutral, and a put buyer or a call seller if you were bearish-to-neutral.

Options selling versus buying is more properly thought of in terms a risk/reward profile that a person wants to assume when he makes a trade. The buyer of the put or call is prepared to lose much or all of the premium he pays if the trade goes against him in return for the possibility of relatively large gains very quickly. The seller of a put or call is interested in making a relatively small profit on an open position where he is either long or short the stock, often with the only potential downside being the opportunity cost of having his stock or short position terminated at expiration if the option is in-the-money. Either way, the option buyer buys risk; the option seller is hedging with an eye on security and a smallish gain.

Well, as with many things, good way to explain option trading strategies is in terms of a dichotomy. Reality has exceptions, and options trading also has an interesting exception to the buy risk/sell to hedge opposing strategies.

I promised to explain one way in which option selling is very risky; this option trading strategy is actually much riskier than buying options. Selling covered calls means that you own the stock against which you write the calls. Selling “naked” calls means that you do not own the underlying stock if you are selling calls, and if you are selling “naked” puts, that you are not short the underlying security.

Wait a minute. How can anything be riskier than the possibility of losing your entire premium amount when you buy a put or a call? Here’s how naked option selling works on the call side (fasten your seatbelt!):

In our initial example of selling IBM 160 calls against shares that we own when IBM is trading at 140, the premium we received functioned as a hedge against a possible downward move in the stock. Believe it or not is perfectly legal to take the premium from the call buyer without owning any shares of the underlying stock. Should the stock close at expiration below 160, the call seller keeps his premium without having to have taken any further position, i.e. lay out any money for the shares of stock, as the seller of a covered call does. Assuming that the writer of a naked call holds his position until options expiration, you can say that he has an infinite return (minus commissions of course!). Sounds wonderful doesn’t it? And so what happens in the event that the stock is trading above the calls’ strike price at expiration?

The naked option seller is required to deliver 100 shares of stock per contract that he has sold. The premium he has received is miniscule compared to the amount of money he needs to pay for a stock position that he will establish at the strike price. In our example above, the naked seller needs $160,000 to buy 1000 shares of IBM at 160 to fill his obligations. You don’t need to do much more than read that sentence again to understand the amount of risk a naked options seller is assuming.

Now in practice, online brokers-in addition to furnishing you with stock option software-require you to maintain equity in your account to cover obligations that you have in delivering stock that you might be obliged to deliver. Still, the possible downside from this trade is such that even though one does not have to purchase shares, you must be psychologically and financially prepared to do so. Needless to say, writing naked puts or calls should only be attempted if you are an experienced options trader, and it is one of those options trading strategies in which most investors will never participate.

My hope is that you have found a fairly comprehensive overview of the two basic strategies for options trading explained here. Please let me know if you would like further elaboration in the comments.

Options Trading Explained-Answers To Your Questions

The site traffic analysis software that I use for stockoptionsexplained.com tells me that there is a huge range of specific questions that people have regarding getting options trading explained to them that I never could have anticipated, as revealed by searches that people perform that lead them to this site. While I hope that the content here is informative enough to explain stock options basics to anyone who’s trying to understand them, I thought there might be value in providing answers to specific questions.

I’ve paraphrased some of these questions; we all tend to type short phrases when we search. Still I’m pretty sure what questions were behind each of these queries.

Do I have to hold my options contracts until the call date?

It’s a good question; if you buy April 100s, can you sell the option before the Friday of the 3rd week in April when the contract expires? After all, the underlying stock might make the move that you anticipate or the bottom might drop out, leaving you deciding to exit your position.

The answer is that selling options is possible at any time before the expiration date. In fact, one undercurrent that you will come to realize as you get options trading explained to you is that only a small percentage of options buyers intend to hold until expiration when they initiate the trade. Some options traders might only hold their puts or calls for a matter of minutes. Leveraged as they are, options can have huge swings in their prices over the course of even one day, and if you are nimble and fortunate enough, making large percentage gains in one day is certainly possible. Be warned though: this is exceedingly difficult to do, and very, very few people can do it with the consistently you’d need to do to justify attempting it. A large percentage of straight put and call buys are losing trades, often 100% losses.

Does buying options require purchasing the stock?

Absolutely not. The whole point of buying a put or call is to benefit from a move in the underlying security without having to put up the funds that would be required to buy or short 100 shares outright. You simply pay the premium amount to buy the contract with the particular strike price and expiration date that you want.

However, if you are writing (aka selling) puts or calls, you will normally own 100 shares of the underlying stock for every call you write, or be short 100 shares of the underlying for every put that you write. This means that you have the shares on hand to deliver should the call option expire in the money. In the case of put writing, you will be short 100 shares of the underlying and prepared to cover (i.e. buy shares) at the strike price. Owning or being short the underlying stock like this means that hedging with options is what you’re interested in, as a way to protect your stock or short position.

The exception to this is writing ‘naked’ calls or puts, without owning or being short the shares respectively. This is exceedingly risky because you will be obligated to deliver shares that you do not own (for calls) or buy shares without already being short from a higher price point (for puts).

Can I “Cash out” if my option doesn’t reach the strike price?

Yes you can, as long as you sell your out of the money option before the expiration date. Remember that when an option expires it only has value if it is in the money. It does have time value associated with it before it reaches the strike price, based on the market’s assessment of the likelihood of it doing so. As expiration draws near however, buying out of the money options becomes more dangerous, simply because there is less time for the stock to reach the strike price.

In practice it’s not unusual to buy an out of the money option and sell it while it’s still out of the money, but closer to the strike price. After all, the vast majority of long option purchases are done not with the intent of eventually taking delivery of stock (for calls) or a short position (for puts), but simply to benefit from relatively fast appreciation of the premium.

Explain “time value” of stock options

The simplest explanation would be that time value equals the premium minus any intrinsic value that the option has. For example, if XYZ is trading at $12 a share and it costs me three dollars to buy an XYZ option with a $10 strike price, the intrinsic value is two dollars and the time value is one dollar.

Note that an out of the money option has no intrinsic value, so its price is comprised only of time value. As the day and hour of an option contract’s expiration approaches, the time value will, not surprisingly dwindle to nothing. This is why an out of the money option expire worthless, and why at expiration an in the money option’s value is equal to the difference between the strike price and the current price of the stock. Using our example, if XYZ is $12 per share at expiration, then the option we bought for three dollars will be worth two dollars, exactly. As a side note, remember that if we took delivery of our 100 shares at $10/share, we could immediately sell them for $12 i.e. a $200 profit.

It’s relatively easy to understand the intrinsic value of options, but investors new to options might be wondering how to precisely calculate the time value component of option. Suffice it to say that books have been written on the subject, but that much of the time-value component of an option premium reflects market expectations not of the direction the stock is likely to move but how much the stock is likely to move between now and expiration day. The word for this is volatility, and intuitively you can see how if the stock has tended to move up and down a lot recently that this will affect the market’s collective notion of the likelihood of a stock reaching a given strike price before expiration.

As high volatility in a stock, all else being equal, usually makes it more likely in the eyes of the market that its options could move enough to make their purchase worthwhile, we can expect these options to have relatively inflated premiums based on the time value component of these options being itself inflated.

I hope these answers to your questions on stock options basics have been helpful. If you have more specific questions on options trading explained please leave them in the comments; I’m confident that I can get stock options explained to anyone on this site, but it’s easier if I have specific questions to answer.

SFAS 123 Guide

Employee stock options are non-standardized call options that aren’t traded on options exchanges, but rather exist as a private contract between a company and its employees (or other parties such as lawyers, consultants, vendors, etc. as a form of compensation). Accounting for stock options is often in the news relative to executive or employee stock option compensation, so I am including a brief explanation of FAS 123 on this site so that if nothing else people can be directed to the authority website on this subject.

Briefly, the purpose of the SFAS 123R ruling, as issued by FASB (Financial Accounting Standards Board, the authority for financial accounting standards in the USA) is to define a fair value based method of accounting for stock options issued to employees and others by corporations as part stock compensation plans. Option “fair value” can be estimated by option pricing models like Black-Scholes, Black-Scholes-Merton model, lattice models or by other methodologies. Corporations then expense the option compensation an asset over the vesting period of the option.

Under SFAS 123 standards it is also acceptable for a company to measure or quantify compensation cost for their stock option plans using an intrinsic value based method of accounting, as covered by APB Opinion No. 25, Accounting for Stock Issued to Employees. See this FASB pdf file for detailed information, as well as a lucid SFAS 123 summary. Also, here is an excellent site that can help companies value employee stock option with an easy to use calculator using the lattice model with variable inputs. I hope this has been helpful; I felt that as you get stock options explained to you, confusion might be avoided if I explicitly cover the difference between exchange-traded options and options in other familiar contexts, such as employee stock options.

Why Options Selling Increases Safety

If you are a new investor looking to diversify your portfolio for the sake of safety, chances are you haven’t really taken a look at stock options for a couple of reasons. First, you might be a little intimidated by the complexity of options. Secondly, you probably associate options with a high level of risk, and this gives you little incentive to scale a learning curve as you’re interested in protecting your money in these uncertain times.

The thing is that buying stock options is only one option trading strategy you can use. Instead of buying an option, which is the right to purchase 100 shares of the stock at a given price point by a certain date in the future, you can take the other side of the trade and sell an option contract that covers shares that you already own. Options selling is usually overlooked by new investors, and this is a mistake.

Here’s what you need to know: options selling means is that the option buyer pays you a small amount of money-known as the premium-for the right to purchase your shares at a given ‘strike’ price, usually a higher price than where the stock is currently trading. If the stock reaches that price before the expiration date the option buyer has the right to purchase your shares at the agreed-to price. Now if the stock continues up beyond the strike price before expiration, you have still benefited by the move in the stock between where it was when you sold the option contract and the price at which the option buyer bought the right to purchase the shares from you. You also, as the option seller, get to keep the option premium that the buyer paid you.

This doesn’t sound very risky does it? The answer is that it is not risky. There are, however, two potential downsides to this scenario if you are selling options. One is that you do not participate in any upward move in the stock above the strike price, at which you sold the right to purchase your shares. For example if you sold the option buyer the right to buy your shares at $100 per share when the stock was trading at $90 per share, if the stock is trading at $120 per share by expiration you must sell your shares at $100 (but you have still profited from the move between $90 and $100).

The other potential downside for you as the seller of the option is that the stock price may fall. Between now and the expiration date the stock may very well be trading lower than where it was priced when you sold the option. But in this case you’re still better off than if you had simply held onto your shares rather than selling the option, as again, remember that with options selling you get to keep the premium amount that the buyer paid you, and you get to keep your shares as the right to buy them at the now far-off strike price is worthless. You have a paper loss on the shares that you own, but your cost basis for the shares is slightly lower due to the premium amount paid by the buyer, that you get to keep.

I hope I’ve shown that there is more to options trading than just taking a gamble. The fact is that many savvy investors use options selling to create an income from their existing portfolio by selling, aka writing options against shares that they already own. As you get stock options explained to you further be sure and paper trade them for a while before actually committing any real money. The options market moves very quickly and the relationship between option premium prices than that of the underlying stock is not always clear cut.