In my previous post, I discussed the basics of Options and what it means if you buy a Put or a Call. Today I want to discuss what it means to sell Puts and Calls – and I don’t mean sell them after you buy them. I mean sell them without having bought them. Is that normal? Yes, it is done all the time.
In options parlance, selling an option without first owning it is called Writing. You can write a put or a call, and you collect the option premium. Why would you do this? Because you hope that the option premium goes down after you sell it. The best case: The option expires worthless. That means you keep 100% of the option premium. That’s extra cash into your brokerage account. It’s ordinary income on your Form 1040, but at least you get to keep part of it. Many options do expire worthless. Option writing is a very common strategy and it doesn’t have to be risky.
Call writing usually happens when you own the underlying stock. Say you own 100 shares of Facebook, which is currently trading at $170 (Wow!). You would be willing to sell your stock for $175 if the price gets there. Instead of putting in a Limit Order to sell at $175, you write 1 Call contract with a strike price of $175, and you collect roughly $5/share +/- in options premium. Then, if FB gets to $175, whoever owns that $175 call that you sold will exercise it and you will have to sell your 100 shares of FB at $175. You still have pocketed the $5 of options premium. The difference between the call writing and the limit order to sell: You collect the options premium with the call writing, but the option could expire, whereas the limit order does not expire. You can see that call writing is kind of a bearish strategy – if you want to keep both the options premium and the underlying stock, you don’t want the price of the stock to increase above the strike price. Call writing is also considered to be a conservative way to generate income if you own the stocks on which you are writing calls. That is a big “if” because, if you write calls on stocks that you don’t own, that is a very risky strategy called Naked Call Writing. You can lose big money if you write a naked call and the stock goes up a lot.
Conversely, put writing is a bullish strategy. When you write a put on a stock, you collect the put premium. Usually, you write a put at a strike price that is below the current price of the stock If the underlying stock price stays above the strike price for the term of the put, the put will expire worthless and you keep the premium. If the stock goes below the strike price of the option, then you may have some trouble: You have to purchase the stock at the strike price. Let’s use my FB example above, with FB trading at $170. Let’s say you write a put with a $165 strike price, and you collect the $5 +/- premium. Then let’s say there is a market correction or there is bad news specific to FB, and FB falls to $150. Guess what? Because you wrote the $165 put, you now own 100 shares of FB that you bought at $165, and if FB is now trading at $150, you have a $15 loss. That’s why put writing is a bullish strategy: You want the underlying stock to either go up or go down just a little so that it stays above your strike price. Unlike call writing, put writing is often done naked, or without owning the underlying stock, although you must have enough cash in your brokerage account to be able to purchase the stock if the market works against you and the underlying stock is “put” to you at the strike price.
Please let me know if you have any questions about this topic. I am trying to write in language anyone can understand. Options can be a difficult topic, but if you understand them, options can be a good way for you to hedge your positions, or in the case of writing, a good way to generate income for your portfolio. Use professional help at first (i.e., contact me!), and thereafter you may feel confident flying solo with your options strategy.