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From zero to hero: selling options
Koen Hoorelbeke
Investment and Options Strategist
Summary: In our new series "from zero to hero" we explain option techniques and strategies and make them accessible for everybody. This article specifically provides an introduction to selling options, often called premium selling and how to make money with them, as well as the associated risks involved.
From zero to hero: selling options
Introduction
In our previous from-zero-to-hero guide, we unraveled the intricacies of buying options, laying a foundation in the vibrant world of options trading. Yet, as the saying goes, it takes two to tango. While buying options is one side of the story, there is another pivotal character in this narrative — the seller.
So, who are these sellers? Could you potentially step into their shoes? How does selling options work, and what does it entail in terms of risks and rewards?
In this guide, we will delve into the other half of the options trading dance — selling options. It's about time we answer these pressing questions, helping you explore the avenues of generating potential profits as an option seller, while understanding the ropes to manage the associated risks adeptly.
Basics of selling options
What does it mean to sell options?
Ever wondered who is on the other side of the transaction when you buy an option? It's the options sellers, individuals or entities selling you the rights that come with the option contract. When you sell an option, instead of acquiring the right to buy or sell an asset at a predetermined price, you are granting that right to someone else. Essentially, you are creating an options contract and selling it to a buyer in exchange for a premium - a fee that the buyer pays upfront.
Why sell options?
Selling options can be a strategic move to generate income. Each time you sell an option, you receive a premium from the buyer, which is yours to keep, regardless of whether the option gets exercised. Here are some reasons why investors choose to sell options:
- Income through premiums: Regularly selling options can create a consistent stream of income from the premiums collected.
- Potential ownership at a lower price: If there's a particular stock you have your eye on and would consider buying at a reduced price, selling put options might be a strategy to explore.
Types of options you can sell: call and put
You've learned about buying call and put options in the previous guide; now let's flip the perspective and explore the inverse strategy:
- Selling a Call Option: When you sell a call option, you're essentially taking the opposite viewpoint of a call buyer, who is bullish on the stock. Let's take an imaginary company, BigCompany, as an example, which is currently trading at $50 per share. You believe that in the short term, the stock will not appreciate significantly, and therefore you decide to sell a call option with a strike price of $55 for a premium of $1.50 per share (or $150 in total, as one contract typically controls 100 shares).
In this case, your break-even point at expiration is $56.50, which is obtained by adding the premium received to the strike price ($55 + $1.50). You would retain the entire premium if the stock price remains below $55. However, if the stock price surges above $56.50, you'd start experiencing losses, since you would be obligated to sell the shares at $55, even though they are trading at a higher market price.
Below is a screenshot that visualizes this concept (it uses other prices, but the principles remain the same). In bullets 1, 2 and 3 the outcome of selling the call is profitable, only bullet 4, a steep rise contradictory to the assumption, is negative.
2. Selling a Put Option: Conversely, selling a put option means you're taking a stance contrary to a put buyer, who is bearish on the stock. Going back to our imaginary BigCompany scenario, if you speculate that the stock will not decrease much from its current $50 price point, you might choose to sell a put option with a strike price of $45, earning a premium of $1.50 per share or $150 in total.
Here, your break-even point is $43.50, which is the strike price minus the premium received ($45 - $1.50). You are essentially betting that the stock won't fall below $45 before the option expires. If the stock remains above $45, you get to keep the entire premium, which turns into your profit. Conversely, if the stock falls below $43.50, you will incur losses as you have a commitment to buy the shares at $45 each, even if the current market price is lower.
Below is an screenshot, showing the concept of selling a put (using different prices, same principles). In bullets 1, 2 and 3 the outcome of selling the put is profitable, only bullet 4, a steep decline against your assumption, is negative for your P&L.
In both scenarios, selling options allows you to earn a premium, which can either cushion potential losses or enhance your profits if the market moves sideways or slightly in your anticipated direction. It introduces a strategy where you can benefit from the market's stability or slight movements, contrasting with buying options, which generally necessitates substantial price swings to turn a profit.
How to profit and manage risk while selling options
Making money through premium collection
The primary way to profit from selling options is by collecting premiums. When you sell an option, the buyer pays you a premium, which is credited to your account. This premium is yours to keep, irrespective of whether the option is exercised. Let’s delve into how this works:
- Premiums as a Safety Net: When you sell options, the premiums you collect can serve as a safety net, adding some cushion to your financial endeavors. Here's how:
- Selling a Call Option: If you are selling a call option, you are agreeing to sell the underlying asset at a specified price within a set period. If you own the underlying asset and are willing to sell it at the strike price, the premium you collect can help cushion any potential decrease in the asset's market value. Essentially, it provides a buffer, securing you some earnings irrespective of the asset's market movements.
- Selling a Put Option: Conversely, when you sell a put option, you are agreeing to potentially buy the underlying asset at a predetermined price. If you intend to buy the asset at the strike price, the premium you collect can offset a potential rise in the market price, acting as a safety cushion that mitigates the higher purchase price.
2. Utilizing Time Decay: Options lose value over time, a phenomenon known as "time decay." As an options seller, time decay works in your favor. The closer the option gets to its expiration date without being in the money, the more its value decreases, potentially allowing you to buy it back at a lower price than what you sold it for, pocketing the difference.
Understanding and managing the risks
While selling options can be profitable, it is not without risks. Here, we outline some of the risks involved and how you might manage them:
- Potential for Large Losses: Selling options can potentially lead to substantial losses, especially if the market moves sharply against your position. It is essential to be aware of the potential losses and to manage your risk appropriately.
- Margin Requirements: When you sell options, you are required to maintain a margin account. This means that you need to have a certain amount of capital in your account as a security. Being aware of the margin requirements is vital to manage your risk effectively.
- Early Assignment Risk: There is always a risk of early assignment when selling options. Early assignment happens when the buyer of the option chooses to exercise their right to buy or sell the underlying asset before expiration. This risk can be managed by keeping an eye on the intrinsic value of the option and being prepared to take action if necessary.
Strategies to mitigate risks
While the risks are present, there are strategies that you can employ to mitigate them:
- Setting Stop Losses: One strategy is to set stop losses to limit potential losses. A stop loss is an order placed to buy or sell once the stock reaches a certain price.
- Spreading: Another strategy is to use spreads to limit potential losses. In a spread, you sell one option while simultaneously buying another, helping to cap both the potential profits and losses. Spreads is what is called a "options strategy", which we will cover in future "From zero to hero"-articles.
- Hedging: Though we are keeping it simple in this guide, know that there are advanced strategies like hedging that can further help in managing risks, which you might explore as you become more comfortable with options trading.
Crafting a strategy and identifying opportunities
Analyzing Market Conditions
To identify lucrative opportunities for selling options, it's crucial to have an understanding of the broader market landscape and the specific conditions surrounding the assets you're interested in. Here are some aspects to consider:
- Volatility: Understanding the volatility of a stock can help in determining the potential premium you might receive from selling an option. Typically, higher volatility leads to higher premiums.
- Economic Indicators: Keeping an eye on economic indicators and news can provide insights into the potential movements of the stock market, helping you to make informed decisions.
- Company Performance: Before selling options on a company’s stock, consider the company’s performance, financial stability, and future prospects.
Developing a Strategy
Once you have a grasp of the market conditions, the next step is to develop a strategy that suits your financial goals and risk tolerance. Here are some strategies commonly employed by options sellers:
- Covered Calls: If you own shares of a stock, you might consider selling call options on that stock to generate additional income. This strategy is known as writing covered calls.
- Cash-Secured Puts: Another strategy is selling put options while having the necessary cash to purchase the underlying stock if it gets assigned. This strategy, known as cash-secured puts, allows you to potentially buy the stock at a lower price while earning a premium.
- Naked Options: For the more adventurous investor, there's the strategy of selling naked options. This involves selling options without owning the underlying asset, a strategy that comes with higher risk but also higher potential rewards.
Tools and Resources
As you embark on your journey into the world of selling options, having the right tools and resources at your disposal can be a game-changer. Here are a couple of suggestions:
- Trading Platform: SaxoInvestor and SaxoTraderGo are excellent platforms to start your options-journey. SaxoTrader Pro is our top of the line platform for advanced trading and research.
- Educational Resources: Continuously educating yourself through reliable resources aids in making informed decisions. Plenty of high quality content can easily be found via search engines, Youtube and others.
Conclusion
Venturing into the world of selling options can feel like discovering a secret garden in the financial landscape. It's a space where you can find new ways to grow your savings and secure a little extra for the future.
Imagine having a toolkit where you not only benefit when stock prices go up but have strategies to pocket gains even when the markets are not on your side. Selling options offers this toolkit, allowing you to play a different game where the moves are more in your control.
With selling options, there's a whole new world of possibilities, from earning through premiums to exploring strategies that can be beneficial in various market scenarios. It's all about understanding and making choices that align with your financial goals.
Dipping your toes into the realm of selling options can provide a unique perspective on managing and diversifying your investments.
Options are complex, high-risk products and require knowledge, investment experience and, in many applications, high risk acceptance. We recommend that before you invest in options, you inform yourself well about the operation and risks. In Saxo Bank's Terms of Use you will find more information on this in the Important Information Options, Futures, Margin and Deficit Procedure. You can also consult the Essential Information Document of the option you want to invest in on Saxo Bank's website.
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