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Selling OptionsIntroductionThe seller of an option, also known as the option writer, receives the option's premium in exchange for assuming the obligation of the option. However, just as an insurance company hopes you will never make a claim against your policy, the option seller hopes that the option will never be exercised. If the option is not exercised the seller keeps the entire premium received for selling the option. However, it is the option buyer, not the seller, who decides whether or not the option is exercised. This is one reason that option sellers assume significantly more risk than option buyers. AssignmentWhen you buy an option you hold the right to exercise the option if and when you choose. By contrast, when you sell an option you assume the obligation of the option if the buyer chooses to exercise. If the option is exercised, you are forced to fulfill the terms of the option. This is known as being assigned. For example, if you sold 1 XYZ JUN 35 CALL and the option was exercised, you would be assigned and required to sell 100 shares of XYZ to the holder of the call at the $35 strike price, regardless of XYZ's market price. Similarly, if you sold 1 XYZ JUN 45 PUT and it was exercised, you would be required to buy 100 shares of XYZ at $45. Selling CallsCall selling is one way to take advantage of a declining stock. Imagine that XYZ is trading at $38 when you sell 1 XYZ JUN 35 CALL for $5 on a bearish expectation. If your expectation proves to be correct and XYZ drops below the $35 strike price, the option will never be exercised and you will retain the entire premium. However, if you are wrong and XYZ remains above the strike price, the option will be exercised and you will be required to sell 100 shares of XYZ to the option buyer at $35. Because there is no limit to how high a stock can trade, when you sell calls and do not also own the stock, you expose yourself to the possibility of unlimited loss.
Selling PutsSelling puts is a bullish position. For example, if XYZ was trading for $32 and you expected XYZ to go up, you might sell 1 XYZ JUN 35 PUT for $5. As long as XYZ traded at or above the $35 strike price, the put would not be exercised and you would keep the $5 premium. However, IF XYZ dropped below $35, the put would be in-the-money and would be exercised. As the option seller you would be assigned, forcing you to purchase 100 shares of XYZ at $35. Furthermore, if XYZ was trading at $26 when the option expired, it would be exercised, and you would lose $4 per-share: the $26 market value of the stock, minus the $35 strike price, plus the $5 you received for selling the put. Covered WriteAs you learned in the section on married puts, buying and selling options can be combined with stock positions to create varying degrees of risk and reward. Another type of options strategy is known as a covered call. Writing covered calls is selling calls on stock you already own. Because you own the stock, you can use your stock position to fulfill the option in the event the call is exercised. In order to be a covered call you must own at least as many shares of the stock as the number of shares represented by the calls. For example let's say you own 100 shares of XYZ and the stock was purchased at $38 per share. To complete the covered call, you could sell 1 XYZ June 40 call at $4. If the stock drops a little, the profit from selling your call will offset your loss on the long stock. If the stock moves to $35 on expiration, you will have lost $3 per share on the stock but made $4 (times 100) on the expired call. This leaves you with a net profit of $100 even though the stock went down. If the stock rallies, then your call will be exercised and you will no longer have either the call or the stock. You will be forced to sell the stock at $40 per share. However, since you also sold the call at $4 you would get to keep this premium. This would be the equivalent of selling the stock at $44 per share (the $40 strike plus the $4 premium). As the example illustrates, covered writes may be a useful way of obtaining additional profit from a long stock position with minimal risk. Synthetic PutA synthetic put is another strategy combining a stock and option position. A synthetic put is created by purchasing a call when you are short the stock. This allows you to cover the short stock position at the call's strike price. Imagine that you were short 100 shares of XYZ at $40 when you bought 1 XYZ JUN 40 CALL for $3. If you had only sold XYZ short and your bearish expectation about XYZ was wrong, the loss in the short position could be unlimited. By comparison, the loss of this synthetic put would be limited to the cost of the call regardless of how high XYZ traded. The disadvantage is that XYZ would have to decrease by the cost of the call before the synthetic put hit break-even, while the short position would be profitable if XYZ traded below $40.
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