In the last post, we talked about buying options and why the time value decay of the option as it gets close to expiration leads to a loss of value. If the stock does not move in the direction that you need it to, the option will expire worthless or with substantially less value due to this time decay. Most options expire worthless or with less value than they had at the time of purchase, so most options buyers lose money.
There is another side to the coin, however. You can make money selling options instead. You would collect the premium on the option (time value plus intrinsic value), and as the time runs out you are likely to find yourself in a position of making money off of the time value decay. The issue with this strategy is that you can sell many too many options – more than your portfolio can support if it moves against you. Most of the time you will make a small amount on each option that you sell, so people are tempted to sell too many in order to make a sizable profit. But sometimes, these options will increase in value enormously as the stock price moves significantly. By overdoing it and selling a lot of options, you can lose more than you have in your account, and end up owing money.
If done judiciously, however, selling options can be a useful component of a value strategy under a limited set of conditions. If you are already familiar with options, note that this set of conditions might be more limited than you think. Make sure to read through the next couple of future posts to understand why.
Essentially, when used properly, selling an option can be a way to buy a stock you want to own or sell a stock you own at a price you want. It is like using a limit order for which you are paid. Let’s give a few examples to illustrate:
Example 1:
You want to own stock in XYZ corp, and are willing to own it for $10/share. Currently it is trading at $12/share which is more than you are willing to pay, but it is close. You find an $11 put option on XYZ with a 3 month expiration trading for $1.10. So, you sell the put option, which gives someone else the right, but not the obligation to sell you the stock at $11/share between now and option expiration. If the price of XYZ is $10.50 in 3 months, you will probably be sold the stock at $11/share, and you will receive 100 shares for an effective price of 9.90 ($11/share purchase price minus the $1.10/share option premium that you collected).
Example 2:
You want to own stock in XYZ, and are willing to own it for $10/share. Currently it is trading at $12/share which is more than you are willing to pay, but it is close. You find an $11 put option on XYZ with a 3 month expiration trading for $1.10. So, you sell the put option, which gives someone else the right, but not the obligation to sell you the stock at $11/share between now and option expiration. If the price of XYZ is $11.50 in 3 months, you will probably not be sold the stock at $11/share, and the option premium of $110 ($1.10 x 100 which is the usual option price multiplier) is yours to keep forever.
In example 1, you get to own the stock for a price that you want when the put option you sold gets exercised. In example 2, you don’t get the stock, but you get to keep some money from having sold the option. As long as you only sell as many put options as you would be willing to buy in shares (1 put option = 100 shares of stock), then you are fine. You also need to have the cash available to purchase the shares if the put options get exercised (we call this a cash secured put). You would get into trouble eventually if you sell so many options that you cannot afford to buy the stock when it is assigned to you (we call this selling a naked put). This would lead to a deficit in your account and bad things like margin calls. You need to use this only to buy what stock you would want to buy at a price you would want to own it.
Now, let’s look at a couple of examples with call options.
Example 3:
You decide you would like to sell your stock in XYZ corp and are willing to part with it at $14/share. XYZ is currently trading at $12, which is less than you are willing to sell it for. You find a $13 call option on XYZ trading for $1.30/share with a 3 month expiration. So, you sell this call option which gives someone else the right, but not the obligation to buy the stock from you at $13/share within the next 3 months. The price of XYZ is $13.50 in 3 months, so you are probably exercised and your stock is called away, forcing you to sell it for $13/share. You have effectively sold your stock for $14.30/share ($13/share + $1.30/share option premium that you collected).
Example 4:
You decide you would like to sell your stock in XYZ corp and are willing to part with it at $14/share. XYZ is currently trading at $12, which is less than you are willing to sell it for. You find a $13 call option on XYZ trading for $1.30/share with a 3 month expiration. So, you sell this call option which gives someone else the right, but not the obligation to buy the stock from you at $13/share within the next 3 months. The price of XYZ is $12.50 in 3 months, so you are probably not exercised, you will continue to own the stock, and the option expires worthless. The $130 ($1.30/share option premium x 100 option multiplier) is yours to keep forever.
In example 3, you get to sell the stock for a price that you want when the call option you sold gets exercised. In example 4, you don’t get to sell your stock, but you get to keep some money from having sold the option. As long as you only sell as many call options as you own in shares in multiples of 100 (1 call option = 100 shares of stock typically), then you are fine (this is called a covered call). You would get into trouble eventually if you sell so many call options that you don’t have stock to deliver (this is called selling a naked call). In this case, you would end up short the stock. If the stock price moves a lot, this would lead to a deficit in your account and bad things like margin calls. Your loss selling call options without stock to deliver could theoretically be unlimited. People have lost their entire fortunes selling call options. You need to use this only to sell what stock you actually own and would want to sell at a price you would want to sell it.
Remember options you sold are not exercised when you want them to be, but only when the owner of the option wants to. Here is an example to illustrate.
Example 5:
You decide you would like to sell your stock in XYZ corp and are willing to part with it at $14/share. XYZ is currently trading at $13, which is less than you are willing to sell it for. You find a $13 call option on XYZ trading for $1.30/share with a 3 month expiration. So, you sell this call option which gives someone else the right, but not the obligation to buy the stock from you at $13/share within the next 3 months. After 2 months, the price of XYZ is $13 with 1 month to expiration, and XYZ is due to pay a dividend of $0.60 / share, and the date on which you are entitled to this dividend is approaching. The call is now only worth $0.40 per share, so the call owner exercises it early to call away your shares and collect the dividend of $0.60/share which is worth more than the time value on the option of $0.40/share. You miss out on the dividend, because it was the right of the call owner to exercise at any time he or she wished.
Now that we have a handle on what selling an option means, we can get into when and where we should sell options. The number one rule is that you must always be sure to sell a put option for stock you would want to own at a price and amount you would want to own it at (and the same goes for selling call options for selling stock). You must never enter into a leveraged position where you will lose more than you can afford.
Now that we have covered the basics of buying and selling options, we can get into some more advanced analysis of when selling options works and when it is not so great. There are many investors that think selling options is a great deal when used to buy and sell stock that they would want to anyway. However, there are some more advanced and not so obvious considerations to take into account which usually suggest even selling options is not the way to go most of the time. I will discuss these more advanced concepts in the next couple of posts.
Leave a Reply