Editor’s note: “DIY Guide to Options Trading” is a three-part series designed to familiarize traders and investors with strategies involving buying and selling options that are designed to help manage risk and potentially increase returns. Part 1 was an introduction to puts and calls. Part 2 looked at buying options. This final installment discusses selling options.
As we discussed in part 2, the extrinsic value of an option depreciates as time passes. However, short option trades can have significant risk. The key to selling options is to understand where the greatest risks and opportunities lie.
To Your Credit
Selling an option starts with the seller receiving a credit. This credit, minus commissions and fees, is the maximum gain for the trade. Many options traders will try to sell an option each month in an attempt to augment their stock returns, which is why some options traders refer to selling options as an income strategy. However, although you keep the credit, it doesn’t guarantee a profit, because the contract obligates you to accept or deliver the underlying stock at the strike price if the option is exercised. So if the stock price moves through the option’s strike price, you could end up with smaller-than-expected profits or even a significant loss. If the underlying moves against you, you may decide to buy the option back for a higher price than which you sold it.
Let’s discuss a few different profit and loss scenarios.
First, suppose a trader sells a put option and receives a credit of $100. As long as the stock climbs or simply stays above the strike price of the put, the trader keeps the $100 minus any commissions and fees. Alternatively, suppose the stock drops a few cents below the strike price prior to expiration. The profit will be smaller than the initial credit, because either the trader would need to buy back the option contract to avoid stock assignment, or she would need to accept delivery of the stock at a price higher than the prevailing price. A third scenario, where the stock falls past the strike price by an amount greater than the initial credit, would likely result in a loss, because if the trader opted to buy back the option before expiration, it would likely be at a higher price than the sale. Alternatively, the trader can accept assignment of the stock at the strike price, which would be higher than the market value of the stock.
Two common option selling strategies are the covered call and the cash-secured put. A covered call combines stock ownership with the sale of a call option. That means the stock shares are available to deliver if the stock rallies above the strike price (thus the term “covered”). Because the trader owns the stock, she’s bullish. But the call is neutral to bearish. Combining the two investments means the covered call is a moderately bullish trade.
The cash-secured put is a short put combined with the available funds to buy the stock if the stock price falls below the strike price. This makes the short put trade bullish. Cash has no bias, but if the stock rallies significantly higher, you would have preferred purchasing the stock rather than selling the put. So, a cash-secured put is moderately bullish.
The best way to try to avoid assignment is to sell out-of-the-money options. Out-of-the-money (OTM) options are those that have no intrinsic value. In-the-money (ITM) options do have intrinsic value and thus have a higher likelihood of assignment. The at-the-money (ATM) option is the strike price that is nearest the current price of the stock. An ATM option will have a delta around .50. Traders often use delta to estimate the chances of an option being in the money at expiration. Therefore, an at-the-money option has about a 50/50 chance of assignment. A 50/50 chance means the ATM option has the greatest amount of uncertainty as to whether it will be in the money or out of the money at expiration. Consequentially, the ATM option has the highest amount of extrinsic value.
So there’s a trade-off between higher premiums and the risk of assignment. The further out of the money you go, the smaller your potential profit. The further in the money you go, the higher your risk of assignment. You’ll have to determine where the trade-off is according to your preferences. Keep in mind that commissions and fees will impact potential profits and losses as well.
When choosing the expiration date for the option strike you wish to sell, you might consider shorter time frames. Why? Because the rate of time decay increases as an option nears expiration, which can help a trade become profitable faster. Of course, there’s a trade-off here, too. Longer expirations will offer higher premiums and greater potential returns. One strategy is to choose an expiration that's about a month away. This provides you the potential to sell an option each month.
Option selling involves trade-offs. Selling options can augment the return profile of a traditional portfolio, but may cap profit, or even incur a loss, if a stock experiences a significant move. Different strike prices and expiration dates also involve trade-offs between risk and return. Consider experimenting with different combinations to find those that best fit your trading style.
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