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Option Selling

Updated on April 16, 2024
Article byKosha Mehta
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Option Selling?

Option selling is an options contract, which is a derivative agreement between two parties to sell an underlying asset at a defined price on a future date. The conditions of the transaction are outlined in this agreement. The buyer of an option contract has the capacity but not the duty to carry out the agreement’s conditions.

Option Selling

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It is common practice to refer to selling options as “writing” options. For example, the seller of a call option, also known as “writing” a call option, is giving the buyer the right to purchase stock from them at a predefined strike price for a particular period, irrespective of how high the market price of the stock may climb during that time.

Key Takeaways

  • They get the option premium upfront and are banking on the option becoming worthless before it expires to earn cash from the sale of options. Selling options can assist create income.
  • Option sellers are in a favorable position as time passes and the option’s value decreases, allowing the seller to record an offsetting trade at a reduced premium.
  • However, selling options may be dangerous when neither an exit strategy nor a hedge is in place, and the market goes in an unfavorable direction.

Option Selling Strategy Explained

The buyer of a call option is granted the right without the duty to purchase the underlying stock at the price that is specified in the option contract as the “strike price.” Simply put, the strike price is the point in time when the option contract will be automatically converted into shares of the underlying security. Likewise, the buyer of a put option is granted the right, without the responsibility, to sell the underlying stock at the predetermined “strike price” of the option. Every possibility has a time limit or a time limit on it.

The up-front cost levied against an option holder is referred to as the option premium. An option with an intrinsic value will have a higher premium than an option with no intrinsic value.

Multiple elements determine an option contract’s value and profitability by expiration. Current stock price, strike price, and time to expiration determine an option’s value. Options have intrinsic and temporal value. The distinction between the strike price and the market price is intrinsic value. The stock’s intrinsic value fluctuates like home equity. A lucrative option is more profound in the money, indicating it has higher inherent value. Out-of-the-money options lose value. Out-of-the-money option premiums are cheaper.

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Types

Following are the two types of option selling:

Option Selling Types

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#1 – Put

Put option selling is done by traders who believe the market and their shares will perform well. The reward for purchasers of put options is precisely the opposite for sellers. The sellers anticipate that the stock price will either remain unchanged or climb over the strike price. A trader will earn cash upfront and may never be required to buy the stock at the strike price is one of the attractions of selling puts.

Traders will earn a profit if the stock price is higher than the strike price when the option expires. On the other hand, traders will only be able to increase their money in a different way than buying puts would. When selling puts, the maximum gain one may realize equal to the premium earned upfront.

The chart given below from TradingView explains the concept. The chart explains the put sale for Apple Inc., using the weekly strike price. It is also possible to adjust the position and sell puts for the monthly strike price. The trader earns profit with an increase in the price of the underlying asset above the strike price.

Source

#2 – Call

When selling a call option, one can buy underlying securities at a predetermined price before a specific date. A premium is paid to the seller in exchange for the seller’s agreement. It transfers the stock for a specific price before a specified date if the buyer requests. The premium is considered the seller’s profit, whether the price increases, remains the same, or decreases. Should it rise, the seller stands to lose the entirety of the premium and maybe even more.

When selling a call option, it is essential to remember that the potential upside (profit) of trade might be restricted to the premium one gets, while the potential downside can be endless. Therefore, there are various call option selling strategies like covered call, naked call, and sell to close.

The graph given below explains the concept. Here, the stock shows a steady fall from March after a big red candle at the end of February. Expert traders will take this opportunity to shorten the stock or sell the call at a higher strike price and take advantage of the fall in stock price. When the price of the stock goes below the strike price, they make a profit.

Source

Examples

Let us look at the following examples to understand the concept better.

Example #1

Let us assume that a person chooses to sell the 2050 strike option for XYZ shares to receive the premium of $6.35. If XYZ share maintains a price equal to or lower than the strike price of 2050, the seller will be able to profit. It means that he can keep the option premium payment of $6.35. Despite this, the profit will stay the same from $6.35.

When the underlying price of the call option rises over 2056.35, the seller begins to incur a loss. The slope of the profit and loss line makes it evident that the losses accrue at one point. It is when the spot value begins to diverge from the strike price. The profit and loss payback for the call option selling is mirrored in the similar payoff for call option buying.

If the spot price remains to trade at any lower than 2050, the maximum profit that may be realized is $6.35. Therefore, there is neither a profit nor a loss at 2056.35.

Example #2

An article published by Financial Post with the heading “Options is a terrific way to lose money unless you’re the one selling them” issues a warning to investors and traders. It emphasizes that the odds are in traders’ favor when they sell options. It also discusses how the expiration mechanism works and how it impacts the seller. The value of every option decreases with time.

The seller of an option is guaranteed that there will be less time to exercise it before it expires as the termination nears. Therefore, the only thing that can truly be guaranteed in the world of investments is time. Therefore, when selling options, one does not necessarily engage in trading equities; instead, one sells the passage of time.

Option Selling vs Option Buying

  • Every person who purchases an option must find a counter-option seller ready to relinquish their claim to the underlying securities.
  • A buyer is ready to pay a premium in exchange for the right to buy an asset when it expires. And an option seller is someone who obtains a premium for giving up his right to the asset till it expires.
  • The option expires once the spot price rises over the strike price at expiry. In The Money, option purchasers profit and profit. The option expires when the Spot price is at or near the strike price at expiry. The option seller earns the premium collected if the option expires in the money.

Frequently Asked Questions (FAQs)

What is option selling?

A derivative agreement among two parties to purchase or sell an underlying asset at a fixed price on a given date in the future is known as an options contract. This agreement stipulates the terms of the transaction. The buyer of a contract for options has the ability but not the responsibility to carry out the terms of the agreement.

How to do option selling?

A buyer can purchase a call or put option from a seller. The seller of a call option is obligated to sell the underlying asset at a specified price if the option is exercised. A put option requires the seller to commit to purchasing the underlying asset at a specific price. As a result, options are rarely put to use, which means they eventually become worthless and lapse.

How much margin is required for option selling?

The margin requirements for stock and index options are the greater of the following three values: 100% of the option proceeds plus 20% of the underlying market value minus the out-of-the-money value.

This article has been a guide to what is Option Selling. Here, we explain it with types and examples and compare it with option buying. You may also find some useful articles here –

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