Selling call and put options can be risky, but when used wisely, experienced traders can use this strategy to pursue their investment objectives. Learn the basics of shorting options.
The term “short” has been given a bad rap over the years. And for good reason. Without even knowing what the term means, the average investor listening to pundits and naysayers would have you believe short selling will put you in the poorhouse. Or they’ll say short selling was part of what sunk the economy just a few years ago. But in reality, although shorting is inherently risky, it can be useful when used wisely. It’s in the hands of a reckless trader that problems can begin.
The term “selling short” simply means you’ve changed the typical order of operations. Most stock trades begin with a purchase, and if at a later date you decide you no longer wish to own the stock, you might sell it. When shorting a stock, however, one sells a stock, then buys it back at a later time, hopefully at a lower price than where it was sold. There are mechanisms that need to be in place in order for short selling to occur—not all accounts qualify, for example. Plus, not all stocks have sufficient shares available to be sold short. But many view the ability to short sell financial instruments as a necessary component of a fair market, as it completes the opportunity to match buyers and sellers at a transaction price both parties deem fair.
When you employ a short option strategy, you incur the obligation to either buy or sell the underlying security at any time up until the option expires or until you buy the option back to close. Unfortunately, that obligation means you may have to either buy a stock higher, or sell it lower, than where it’s currently trading. In a nutshell, if you’re forced to fulfill the obligation that may arise from a short option position, you’ll be forced to do something you wouldn’t otherwise do. In other words, short option strategies involve trade-offs.
In the case of a short call option position (see figure 1), you incur the obligation to sell the stock at a set price, but you don’t own the underlying stock and there’s no limit to how much higher the stock can rise before you may have to buy it. With a short put option position, you incur the obligation to buy the stock at a set price. And although the stock could drop considerably before you decide to sell, your risk is technically limited because stocks cannot drop below zero. So why do it? There are two main reasons experienced options traders might employ the short put strategy: (1) to buy the stock at a lower price than where it’s currently trading, or (2) to speculate on a stock’s direction and collect periodic income premium.
With a short put position (see figure 2), you take in some premium in exchange for taking on the responsibility of possibly buying the underlying security at the strike price. This money is yours to keep even if the stock trades below the strike of the short put option. At any time prior to expiration, the person who is long the put has the right to exercise the option. The likelihood of exercising increases if the stock trades at a price that’s lower than the strike price. In that case, you’ll probably be assigned on your short put position, meaning you 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 a share to own it. You could sell the XYZ January 60 put for $2 per contract, obligating you to pay $60 per share for XYZ stock if assigned—exactly what you wanted. But since you’re collecting $2 for the put, your net cost for the stock would be $58 per share (plus commissions and fees) if you are assigned.
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 would not be entitled to a dividend. That said, keep two things in mind. First, if you happen to get assigned on your short XYZ puts, then you’d be forced into taking delivery of the stock, thereby granting you the right to all future dividend payments so long as you remain the stock owner.
Second, all American-style 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 did not offer a dividend, all else being equal. Among other factors, the deeper in the money the put option happens to be, and hence, the greater the likelihood that your short option is assigned and converted to stock, the greater the adjustment for the dividend.
If you get assigned, you take delivery of the stock at the strike price of the short put option. So what now? Here’s a short option strategy to consider: Since you took in some premium via your put sale prior to buying the stock, how about taking even more premium by selling a call option after you buy the stock?
Suppose the stock settles at $59.75 per share at expiration and you get assigned, thereby forcing you to buy shares of XYZ stock. On the following market opening after expiration, you note that XYZ is trading at around that same level, just below $60 per share. At this point, you could sell the XYZ February 60 call at, say, $3. This premium is yours to keep regardless of where XYZ settles at expiration.
If XYZ stays below $60 per share until expiration and you don’t get assigned, the February 60 calls expire worthless, you keep the $3 premium. On the other hand, if XYZ trades above $60 per share prior to, or at, expiration, then you’d likely be assigned on your short call option. In this case, you’d be forced to sell your stock at $60, which is the same price at which you were forced to buy it in the previous expiration. You would be no worse off, and in fact, you’d probably be slightly better off, since in addition to the premium that you collected when you sold the put, you’d also have the premium collected when you sold the call, less the applicable transaction costs like commissions, contract fees, and assignment fees.*
Selling short puts can be a great way to buy a stock you were committed to buying anyway, while allowing you to collect some additional premium through the option sale. You just need to be prepared to buy the stock at a price higher than the current market while it’s trending down. At first glance the short strategy may seem to be adding another layer of complexity or risk. Whether or not you’re assigned on your short put option, the premium you collected during the option sale is yours to keep.
Ready to consider your (short) options? If you’re a TD Ameritrade client, you might consider using Option Hacker to help you find candidates. Follow the steps in figure 3 to start scanning the possibilities.
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The naked put strategy includes a high risk of purchasing the corresponding stock at the strike price when the market price of the stock will likely be lower.
The risk of loss on an uncovered call option position is potentially unlimited since there is no limit to the price increase of the underlying security.
Naked option strategies involve the highest amount of risk and are only appropriate for traders with the highest risk tolerance.
The covered call strategy can limit the upside potential of the underlying stock position, as the stock would likely be called away in the event of substantial stock price increase. Additionally, any downside protection provided to the related stock position is limited to the premium received. (Short options can be assigned at any time up to expiration regardless of the in-the-money amount.)
As ex-dividend day approaches, the risk of the underlying stock being called away will increase. If this happens, eligibility for the dividend is lost.
Market volatility, volume, and system availability may delay account access and trade executions.
Past performance of a security or strategy does not guarantee future results or success.
Options are not suitable for all investors as the special risks inherent to options trading may expose investors to potentially rapid and substantial losses. Options trading subject to TD Ameritrade review and approval. Please read Characteristics and Risks of Standardized Options before investing in options.
Supporting documentation for any claims, comparisons, statistics, or other technical data will be supplied upon request.
The information is not intended to be investment advice or construed as a recommendation or endorsement of any particular investment or investment strategy, and is for illustrative purposes only. Be sure to understand all risks involved with each strategy, including commission costs, before attempting to place any trade. Clients must consider all relevant risk factors, including their own personal financial situations, before trading.
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