While selling options can be risky, I believe in the saying “options are made to be sold.”
Selling options is a great way to generate income. To provide a recap, option sellers want the stock option contracts they sold to decrease in value, eventually becoming worthless.
When options expire worthless, sellers keep the options premium they initially collected.
Considering options trading
Options are considered a type of security called derivatives –– meaning their price is dependent or derived from another asset.
Trading options depend on strategy, and to some degree, speculation. Traders who feel bullish can buy a call or sell a put; and, if you’re bearish, you can buy a put or sell a call.
Call and Put Options
When you buy an options contract, you get the right but not the obligation to either buy or sell the underlying asset at a specific price on or before the expiration date.
Buying a put option allows you to sell a stock. Alternatively, buying a call option gives you the right to buy a stock.
If you’re interested in an options trading guide, puts and calls for dummies, then click here.
Buying / Selling Calls and Puts
Basically, there are four choices a trader can make with an options contract:
- Buy calls
- Sell calls
- Buy puts
- Sell puts
Traders who buy contract options are called holders. Meanwhile, people who sell options are called writers of options.
Let’s consider call options first. Buying a call gives traders a potential long position in the asset; meanwhile selling the call will give you a short position.
Holders benefit from options because they have the choice of whether or not to exercise their rights to buy. Buyers prefer options because it limits the risk to only the initial premium that they paid.
On the other hand, buying a put gives traders a potential short position in an underlying asset. Selling the put gives you a potential long position in the underlying stock.
Writers usually will manage or roll a position to avoid having it expire in the money.
Selling options has a very high probability of profit because there’s a large “safety net” when selling an out-of-the-money (“OTM”) put option. The underlying stock can move up, sideways or down, and the put writer will still make money.
Option sellers get in trouble if the underlying asset moves more than the expected move and if they trade too many contracts.
Why Sell Options?
Understanding time decay, or the rate of decline in the price of an option, is critical for option sellers. Sellers know that time decay accelerates as the options contract gets closer to expiration.
Once an option seller makes the trade, they eventually want the option to expire worthless, or decline in value so that they can close out the position for a large gain, so they can keep the premium without having to buy or sell shares of the underlying asset.
Overall, selling options is considered a positive theta trade –– which means sellers benefit as time passes because each day the option loses value.
Sellers can benefit by closing their position early and buying back the option at a lower premium – by doing this, they decrease the gamma risk of the position.
How Options Selling Works
To understand how options selling works, you should know about the difference between naked and covered strategies.
Covered calls involve selling options while holding existing shares.
Investors who have held a long position in an asset can sell call options for a steady income stream.
Covered calls are a good strategy for flat markets, although the seller relinquishes some of the upside potential of the underlying stock when selling calls.
Naked selling strategies are riskier, but they can be a valuable way to diversify a portfolio, generate income and realize substantial returns.
Basically, naked writing is a strategy where the underlying securities aren’t owned and options are written against underlying stocks.
To justify why a trader may want to sell an option, it’s critical to understand what type of option is being sold and what benefits are expected from selling the options.
Selling Naked Puts
Traders who sell naked put options have a strong belief that the underlying security is going to rise (or not fall enough to challenge their strike price).
Sellers collect option premium when writing the option for the right to buy the shares at a specified strike price.
The writer benefits because they get to keep the premium if the price closes above the strike price.
Selling Naked Calls
Investors sell naked calls if their outlook on the asset is that it’s going to fall, or not increase beyond the strike price.
Sellers collect option premium when writing call options for the right to sell the shares at a specified strike price.
When selling naked calls, writers get to keep the premium if the price closes below the strike price.
I hope you enjoyed this options trading guide.
If you’d like to learn more, visit https://BestStockStrategy.com and enter your email address to receive over $400+ of valuable free options trading materials.