Selling call and put options can be risky, but when used wisely, experienced traders can pursue investment objectives. Discover the basics of shorting options.
With every transaction, there’s a buyer and a seller, which is true for options trading too. Instead of buying a call or put option, you can sell them, which means that instead of paying the premium, you can collect the premium, and instead of time value working against you, it can work for you. Of course, selling options comes with significant risks too. Here’s a little background on what you need to know before you start selling options.
Please note that options trading involves significant risks and is not suitable for everyone. Certain requirements must be met to trade options through TD Ameritrade. Not all clients will qualify. Naked options strategies involve the highest amount of risk and are only appropriate for traders with the highest risk tolerance.
Generally, you buy a call if you’re bullish and buy a put if you’re bearish. However, selling a call is usually a bearish strategy and selling a put is usually a bullish strategy.
Selling or “shorting” options obligates you to either buy or sell the underlying security at any time up until the option expires or until the option is bought back to close. In the case of a short call options position (see figure 1), you incur the obligation to sell the stock at a set price. However, if you don’t own the underlying stock, then the risk of loss is unlimited because there’s no limit to how much higher the stock can rise before you may have to buy it back.
With a short put options position, you accept the obligation to buy the stock at a set price when the market price of the stock will likely be lower and could continue to fall. And although the stock could drop considerably before you decide to sell, the risk is technically limited because a stock’s price cannot drop below zero.
There are two main reasons you might employ a short put strategy: to potentially buy the stock at a lower price and to collect options premiums. With a short put position (see figure 2), you take in some premium in exchange for taking on the responsibility of potentially buying the underlying security at the strike price. This money is credited to the account, and you keep it even if the stock trades below the strike of the short put option.
At any time prior to expiration, the trader who owns the put has the right to exercise the option. The likelihood of the option being exercised increases if the stock trades at a price that’s lower than the strike price. In that case, the short put seller would have a higher probability of assignment, meaning they’d have to buy the underlying stock at the strike price.
Let’s say you’re mulling over the idea of buying 100 shares of XYZ stock currently trading at $64.50. However, you don’t want to pay more than $60 per share to own it. You could sell the XYZ January 60 strike put for $2 per contract, obligating you to pay $60 per share for XYZ stock if assigned—exactly what you wanted. But because you’re collecting $2 for the put, your net cost for the stock would be $58 per share (plus commissions and fees).
If assigned, a trader takes delivery of the stock at the strike price, and it becomes part of their portfolio. They now have the right to hang on to the stock or sell it.
It’s true that if XYZ stock happened to pay a dividend, then by owning XYZ you’d be entitled to that dividend. By being short a put in XYZ stock, on the other hand, you’d not be entitled to a dividend. That said, keep two things in mind.
First, if you happen to get assigned on your short puts, then you’d be forced to take delivery of the stock, thereby granting you the right to all future dividend payments so long as you remain the stock owner.
Second, put options are adjusted to some degree for upcoming dividends. Puts sold on dividend-paying stocks are built to trade at a slightly higher premium than where they otherwise would trade if the underlying stock didn’t offer a dividend, all else being equal. Among other factors, the deeper in the money the put option happens to be, the greater the likelihood that your short option is assigned and converted to stock, the greater the adjustment for the dividend.
Like selling a put, selling a call provides a premium in exchange for an obligation (to sell shares of stock at the strike price). Now, suppose you want to sell a call option on a stock that is trading at $59.75. Imagine you sold a 60 strike call at $3. This premium is credited to your account, and you get to keep it regardless of where XYZ settles at expiration.
If XYZ stays below $60 per share until expiration and you didn’t get assigned, the 60 call will expire worthless, and the $3 premium is realized. On the other hand, if XYZ trades above $60 per share prior to, or at, expiration, there is a high likelihood of assignment on the short call option.
If your short call is assigned, you’d be forced to sell the stock at $60. If you don’t own the stock, you’ll need to buy the necessary number of shares or you’ll end up short those shares, which will require the use of margin and the price of the shares could rise, leading to losses, or fall, leading to gains.
Options for companies that pay a cash dividend usually have lower call premiums because the stock price drops to reflect the dividend. Despite this effect, a call seller does carry the risk of the buyer exercising the call to grab the dividend before its paid. And the closer the ex-dividend date approaches, the higher the risk.
Selling options can be a good way to collect premiums and short puts can be one way of potentially buying a stock you were committed to buy anyway. You must be prepared to buy or sell the stock the price moves past your strike price. But now you have some basics under your belt that can help you along the path of selling options.
Ready to consider your (short) options? If you’re a TD Ameritrade client, you might consider using the Option Hacker to help find candidates. Follow the steps in figure 3 to start scanning the possibilities.