When a trader decides to sell options, he gets to keep the option premium which he sold it for. Eventually, over the life of the option, the option loses its time value.
Without any major price moves of the underlying security, the options that the trader sold is likely to expire worthless. When the option expires worthless, the trader gets to keep the entire premium which he sold it for initially. When the options expire worthless, the trader is in effect buying back the options at a cost of $0.
While call sellers want the price of the underlying to decrease, put sellers want the price of the underlying to increase. In summary, if you do sell options, you would want those options to expire worthless so that you get to keep the option premiums as profits.
|Basic Option Selling Strategy||Stages in executing option selling strategy|
|Write Naked Call||● Sell at high premium when implied volatility is high
● Price of Underlying security falls
● Buy to close call option at a low premium or allow call to expire worthless
|Write Naked Put||● Sell at high premium when implied volatility is high
● Price of Underlying security increases
● Buy to close put option at a low premium or allow call to expire worthless
An example of naked option selling done right
Trader A predicts that the price of a security is headed downwards. He validates this by using economic analysis, fundamental analysis and technical analysis. He sells a XYZ December 50 call contract ( 50 is the strike price) and collects $200 in premium(credit). By the expiration date of the call contract in December, the price of the underlying security was trading at $10. The call expires worthless and Trader A gets to keep the credit(premium) received.
Trader B predicts that the price of a security is headed up. He validates this with economic analysis, fundamental analysis and technical analysis. He sells a XYZ December 100 put contract and collects $200 in premium(credit). Eventually, the price of the security goes up and the put contract expires worthless. Trader B gets to keep the entire premium(credit) for writing the put.
When a trader or investor does covered selling, it means that he also has an open position in the underlying security. If he executes a covered call, he has a long position on the underlying security and a short position on call options.
To make this clearer let us look at an example.
Amazon is currently trading at $640.95 . You own 100 shares of this company right now. You decide to sell 1 current month call options contract with a strike price of $642.50 at a premium of $13.20. What you have just done was to execute a covered call. You own the underlying security and you just shorted a call options contract. If the price of Amazon does not go beyond $642.50, in about 2.5 weeks, these options will expire worthless and you get to keep the options premium. You can think of this as a way to collect rent on the stock you own or you can think of this as a way to reduce your cost of acquiring the underlying security. This is the covered call strategy.
Another strategy of covered selling is executing covered puts. This time, a trader has a short position on the underlying security and short position on put options.
So let us examine the same company, Amazon. Amazon is trading at $640.95. You short 100 shares at $640.95 You short a current month, in the money put at a strike price of $642.50. If the price of Amazon goes down to $600, you have lost $40.95 per share. In total you have lost 40.95 x 100 = $4095 on your short stock position. But since you have shorted a put option, you have collected a premium of $16.45. In total, you collect :$16.45 x 100= $1645 of premium. You, the seller of a put is obligated to buy 100 shares at the strike price of $642.50. So, you have lost on your stock positions but gained a little premium. For a covered put strategy, the loss can be unlimited.Of course, this is a real world example and not a textbook example. In a textbook example of a covered put, the strike price of the put option sold is equal to the buying price of the underlying security.
Sell options when implied volatility is high
An option’s premium is significantly influenced by the implied volatility. When implied volatility is high, options premium would be high as well and a trader should consider selling the options at this point. When implied volatility is low, the options premium would be lower with all things being equal. A trader should not sell options when implied volatility is low because he gets the lower price then.