Table of contents;
What are options?
What are some reasons people buy options?
Why is there an advantage to selling options?
Can we control our risk when selling options?
What are different strategies we can use to sell options?
Understanding more about options valuations.
A wrap up of thoughts on selling options for income.
What are options?
When someone buys an option on a stock or other trading asset they’re buying the option to make a trade later on that asset, without having the obligation to make a trade.
In all examples here to keep things simple we’ll use a hypothetical example of “Stock X” and this stock will be trading at $100.
Call options -
A call option is a “Bullish” bet on a stock. Betting it will rise in price. So if I think stock X is going to go to $120 some time in the next 6 months I can buy a call option for $118 while price is $100. This means at some time in the future I have the option to buy this stock for $118. If in the future the stock is $120 +, it makes sense to buy it lower at $118. I’d want to use my option. However, if the price is under $118, it makes no sense to buy at my option price (I can buy cheaper in the regular market).
So when I am buying a call option I am giving myself the option to buy at the price of my option if the market is above there. Meaning I can buy the stock and sell it instantly to the market for a profit. But I am not obligated to buy the stock if the price is under my option price. I would just lose what I paid for the option (And this means my risk is predefined).
Put options -
A put option is a “Bearish” bet. Everything works the same as a call option but when you buy a put option the option will benefit if the market drops in price. If I buy a stock X put for $90 while the price is $100 it means I can force someone else to buy the stock off me at $90 in the future, but I am not obligated to make any trade if I do not want to. So if the price was to fall to $70 I’d be able to make someone give me $90 for the stock.
What are some reasons people buy options?
Options are one of the earliest forms of trading and it was first intended as a means for the hedging of fluctuating prices in things like wheat, corn, orange juice and other commodities. A farmer not knowing what the price of wheat being when their harvest is ready is a big risk to them when planting. Buying an option on the wheat gives them a sure price they can sell it at in the future and it acts as an insurance policy for them.
To this day options are bought by shroud investors and business owners to protect themselves from market risks. Options can also be bought by speculators hoping to make gains larger than they’d make just buying or shorting a stock (Options come with more leverage and can have higher rewards in the times they pay off).
Options can be bought both to speculate but also just for the practical value the protection of the option gives the buyer. For example if someone bought stock X at $10 and it is now $100 and there’s risk of there being some event that will cause losses in stock X’s share price, it makes a lot of sense to buy a put option and secure the profit you have made.
What are the advantages of selling options?
Everyone option someone buys someone else is selling to them. Let’s talk a bit about what happens when you’re the person who is selling the option instead of buying it.
Selling put options -
Usually people sell puts on stocks they would not mind owning at a price lower than it is at the time of them selling the option. When stock X is trading at $100 someone may think it’s a great deal if they can buy this stock at $70. They can then sell put options for $70. This gives them the obligation to buy the stock at that price if the option seller chooses to make them later (Which they will do if the price goes under $70).
For people looking to invest in stocks over long periods of time and to accumulate their stocks at the best possible prices this a good strategy to build up that portfolio. Let’s look at all the different outcomes of selling this option so you can understand the nature of risks taken and the reward potential for them.
Deconstructing the option trade;
How much stock you commit to buying - When we trade in options we always trade at least 100 units of stock. You can not less. So if we’re selling an option for $70 we’re committing to buying 100* $70 = $7,000 worth of stock.
How much risk do we take - The losses of the stock purchased. 100% loss would be $7,000. 50% would be $3,500. And so on.
What conditions do we have potential loss - If the stock trades at or under our strike price of $70 where we become liable to have to buy the stock and take the risk of that.
What if the option does not fill - If the strike price is not met, we get to keep whatever we sold the option for. This generates income.
How much do I make if the option does not fill - This depends upon different variables and we’ll talk a little more about these later in the post.
So our potential outcomes are either stock X drops to our strike price and we buy $7,000 of stock. If we buy the stock we have the normal profit/loss potential of owning the stock, but we are getting to buy it while it is cheaper than it was before. If this price does not hit, the “Option expires worthless” and this means we keep everything we made selling the option.
We can sell the option many different times. For example we might sell a 3 month option through January to March and then if that expires worthless we can sell the same strike for March - June. And so on. We can keep selling the option and getting income while we wait to be filled on the stock position.
Selling call options - If you want to bet a stock will stop rising (Or start dropping) you can sell call options on this stock. When selling a call option you agree to sell the stock later at the price you’ve sold the option for, should the option buyer want to make you. So we might sell a call option on stock X for $130. We would then be obligated to sell 100 shares of this stock at that price. If the stock went to $150 we’d have to buy 100 shares of the stock from the market at $150 to sell them at an instant loss at $130.
Call options can be sold on stock you already own, knowing as a “Covered call”. This means you already have 100 shares of the stock to give away. You won’t have to buy them from the market and therefore can not make any real loss (Although you can lose hypothetical gains having to give away the stock at less than it trades in the current market). Selling calls on a stock you do not own is known as a “Naked call” and this has hypothetically uncapped loss potential - it’s a very dangerous bet and strategies have to be used to nullify this endless downside. More on that later.
Selling covered calls is probably the lowest possible risk bet in the markets. Selling naked calls is one of the highest risk bets in the market.
Round up of advantages of selling options
When using the right sorts of strategies selling options can produce us income while we are waiting to buy stocks. We can use them to make money on stocks we already own while they are moving down or sideways. Most options that are sold expire worthless. So statistically our odds of winning trades when selling options is high.
Can we control our risk when selling options?
Yes. To be successful, you must. Although the odds are that you will win a lot of the options you sell it only takes one bad trade to wipe you out. People have gone into debt and are even bankrupt from selling naked call options and even the lesser risk selling of put options can leave you exposed to losing everything you put up as collateral on the trade.
Before embarking on any serious attempt to generate cash flow using the options market is it highly recommended you take time to learn how to make sure you’re protecting the maximum exposure you have to the market. This can be done, but you have to learn how to do it and then be disciplined in doing so.
What are some strategies we can use to sell options?
The times when options are really risky is usually when options are used to bet on only one outcome and not to place hedging options against other outcomes. We can protect against these sorts of risks by using “Options spreads”. I won’t go into detail on how spreads work in this post but when we use spreads we’re buying one option and selling another and by doing so we give ourselves a known area of risk.
There are also more advanced ways to offset risk in options by either going long or short a portion of the 100 shares in the underlying market and this reduces the maximum risk of the option. For example if you sell a call option but also buy 50 units of that stock you have created a position which is half a covered call, far less risky than a fully naked call.
Understanding more about options valuations.
The value of an option is made up of a few variables. These are known as the “Greeks”. The main variables to consider is how much time there is in the option, how volatile the market is at the time and likely to be during the timeframe of the opinion and how far the price actually moves. Options are always in a state of flux based upon these factors.
Since this is an introduction guide this post will not go extensively into how the different Greeks work or how to build strategies around them. It is essential to have a good grasp of how these affect options prices and the implications of this for options buyers and sellers before getting seriously involved in the options market.
A wrap up of thoughts on selling options for income
A well thought out, properly managed and risk quantified strategy of selling options is one of the very best ways to take advantage of the fluctuations in markets. A large number of people who make their living from the market incorporate some form of selling options to it. There are even those who sell options as their primary source of income.
The selling of options offers frequent opportunities to bet against things that are not going to happen most of the time. When using this as part of a bigger model you can use it to accumulate stocks at cheaper prices and even end up getting stocks free or at a profit by selling multiple options before you end up having to buy the stock.
As you learn more about different strategies to use options as a means of reducing the price you have to pay, or making income from stocks in a flat market and even just understanding the times the market has moved too much recently and is likely to calm down in the near future you can build more robust strategies to make income from this.
It is not easy! I do not want to encourage you to think this is something you can whimsically wander into and find lasting success. Lasting success is there to be obtained, but so is rapid failure. To be successful you have to commit to making the effort and learning all the different nuances of bet optimisation and risk reduction.
This has been a brief introduction guide to selling options. It is not intended to give you enough information to go into the marketplace and start to sell options immediately. I sternly warn against that and encourage you to educate yourself more on this if it is something that interests you.
If you have significant interest in selling options for income, have some capital to back up doing this and have motivation to learn something now to benefit you in the decades ahead get in touch with me. I can maybe set up something with more directly useful information and practical strategies to use the options markets for income.
If you found this post useful, you can find more of my posts on Reddit at Earn passive income through various online sources. (reddit.com)
