Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Options: When to Sell, Not Buy

Selling options is an aspect of trading that investors should become familiar with. Sometimes, it is in the investor’s best interest to sell, or write, options. When you write options, you'll have a very different set of risks/rewards versus purchasing them. But before we delve into that topic, let's first take a look at the two forms of options writing:

  • Covered -- The writer of the option owns the underlying stock or asset.

  • Naked -- The writer of the option does not own the underlying stock. In this instance the writer is most likely speculating on the direction the stock will move and not hedging a position.

The safest way to sell an option is to write what is known as a "covered call." This strategy is so safe, in fact, that it is suitable for most retirement (IRA) accounts. In this type of trade, the investor sells a call option on an underlying stock that he already owns. This trade is usually made in an effort to generate additional income from a particular holding.

Here is how the process works:

Assume that in January an investor owns 100 shares of IBM stock, which currently trades at $100. Over the course of the next month, the investor does not believe that IBM will trade for more than $105. With this expectation, the investor would be wise to sell an option contract on IBM for $105 to another investor who feels differently. Suppose that an IBM FEB 105 option sells for $3. The investor who sells the option will therefore receive $3 today (or $300 total, since each option represents an interest in 100 underlying shares) in exchange for selling the option (even though the option does not expire until next month).

Now consider the following scenarios:

IBM trades at $110 at expiration. In this scenario, the seller was too conservative in his estimate of where IBM would trade this month. The seller will therefore be obligated to sell 100 shares to the buyer of the call option for $105 each. The net impact to the options seller is $105 (for selling the stock) + $3 (for selling the option) to yield $108. This will be the net result for the seller no matter how high IBM's shares soar. So, as you can see, by selling a covered call, the option seller has limited his upside potential. In return, he received $300 for the sale of the option contract.

IBM trades at $103 at expiration. In this scenario, the seller was accurate in his estimate. The seller is not obligated to sell his shares because the buyer would not want to buy them at $105 (after all, the buyer could instead purchase them in the open market for just $103). The net result is that the investor generates $300 in additional income while still keeping his/her stock, which also gained $300 during the month.

IBM trades at $95 at expiration. In this scenario, the investor overestimated the return on the stock. Although the investor will have suffered a $5 loss in his/her stock holdings, this loss will be buffered by the $3 premium received for selling the call. The investor will still hold his shares, and will have lost just $200 in total (versus $500 if he hadn't sold the call option).

The covered call strategy works best when the investor plans on holding the underlying stock for a long period but does not expect a significant increase in the near term. As you can see from the diagram above, the investor is limiting his upside potential to $8 in return for a guaranteed $3 premium. If shares of IBM tank, then the investor's losses can still be significant. However, if the stock declines, then thanks to the options sale the investor will always be $3 better off than if he had merely held the stock alone. (Please note that you can also employ a similar strategy by shorting a stock and selling a put against the position. This is referred to as writing a covered put).

Naked Option Writing

When an investor sells an option on a stock he does not own, it is referred to as selling a “naked” options contract. This strategy is mainly used for speculating. The investor must be very confident about the direction the stock will go and have the resources available to cover any mistakes.

For obvious reasons, naked option writing is only available to experienced or expert traders. This is because the investor is taking on a possibly unlimited amount of risk in exchange for a fixed premium. Why is the potential risk unlimited when it comes to selling naked options? Well, in the example above, the investor already owned IBM stock, so even if IBM rapidly appreciated (the worst-case scenario), the investor could simply sell his stock for a lower-than-market price. However, if the investor had written a naked call option (in other words, he did not own IBM and still sold this call option), then the result could have been devastating.

Suppose that IBM developed a revolutionary technology and the stock price doubled in a short period of time to $200 (not a likely scenario, but it can happen nonetheless). The investor who sold the option for $3 would now have to sell IBM stock to the option purchaser for the agreed upon price of $105. However, the market price of IBM stock is now $200. In order to deliver the stock to the option buyer, the option seller must purchase IBM in the open market for $200, then sell those same shares immediately to the option buyer for $105. If you factor in the $3 that the option seller initially received for selling the contract, then his total losses would be a whopping $92 per contract in this case.

Note: To offset this risk of dramatic losses, some investors will sell an option with a lower strike price and simultaneously purchase an option with a higher strike price. This technique lowers the return the investor receives, but it also limits the losses that he might incur.

Conclusion

There are many instances in which you might find selling options appropriate. If you are determined to hold on to a particular stock for the long haul, then we suggest look into the process of writing covered calls. This technique will help you add real income to your portfolio and compliment your holdings. If you plan to hold a stock for the long haul anyway, then the worst that can happen is you might be forced to sell your stock at the end of the month (but for a price you would gladly have accepted at the beginning of the month).

You should note that in the long run, since options tend to lose their value as they approach their expiration date, options sales tend to be much more profitable than options purchases. If you decide to sell options naked, then please use extreme caution and be cognizant of losses you might face. This strategy may work 9 out of 10 times, but you better be prepared for the one time it may dramatically go against you.