Options provide an alternative to stocks and bonds for investors who want to delve into derivative securities. These types of investments are linked to the performance of another financial asset and rise or fall in price accordingly. Buying and selling options allows you to hedge your bets since they cost less than the actual shares and give you an automatic out if the market doesn’t behave how you predicted. In fact, many investors use these securities as a type of insurance policy against loss. Here’s how selling options before expiration works in the stock market world.
What Is Selling Options Before Expiration?
When purchasing or selling options, investors can select either call or put options. With call options, you purchase the right to buy a specific stock at a pre-set price. With this arrangement, you think the stock price will rise; if that occurs before the option expiration date, you can call your option and lock in the lower price, resulting in an instant profit.
A put option works the opposite way. You purchase the right to sell specific stock shares to a person or entity at an agreed-upon price. If the stock price drops, you’ll still get the higher price for the designated shares if you exercise your put option before the expiration date.
Steps to sell options before expiration include:
- Understand the concepts of options trading, including the strike price, the premium price, the call option, the put option, the expiration date, in the money, and out of the money.
- Review your individual investment plan to choose options that meet your needs.
- Monitor the underlying stock or asset to inform the decision about whether to sell, exercise, or expire your option.
- Review the concepts governing the value of options and the profitability of a sale.
- After you sell an option, your level of profit or loss depends on the movement of the market and whether the buyer decides to exercise the option or allow it to expire.
Know the Lingo
First, you should understand the vocabulary of options trading and have a thorough understanding of key concepts. These terms will get you started:
- The writer is the person selling the option.
- The strike price is established by the writer for each option they sell. For a call option, a $10 strike price means that if you exercise your option, you can buy the underlying stock at $10 per share rather than at the market price. For a $10 put option, you could exercise your option to require someone else to buy stocks you own at $10 a share, even if they are priced lower on the open market.
- The premium is the cost of the option. Instead of buying the actual stock, you are buying the right to buy or sell it later at a designated price.
- The expiration date is the deadline to exercise your option. It will be established in the options contract. Can you sell a call option before the expiration date? U.S.-style options allow you to exercise your option on or before the actual expiration date, while European-style options cannot be exercised early.
- An option is in the money when the stock’s market price exceeds the strike price.
- When the strike price is higher than the stock’s market price, an option is out of the money.
Decide Which Options to Buy
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The answer to the question about which options are best depends on your individual investment goals, profit objectives, and risk tolerance. Many new investors branch out into options of popular stocks like Micron Technology, Google, Amazon, and Facebook. These companies offer ample trading opportunities for options, often with hundreds of thousands of securities transactions each day.
Prepare for the Expiration Date
In most cases, it makes sense to wait for the expiration date to approach before acting on your option. You can either let it expire, exercise it on or before the expiration date, or sell it to someone else. If you decide to resell your option, you can profit from the premium amount corresponding to the time left until the expiration date. This concept is called time value.
For example, let’s say you paid $5 for a $100 stock option. As you await the expiration date, the stock price and the premium price of call options both increase. Often, you can earn a higher profit by selling the option than you could earn by selling the stock itself.
When you decide to sell a call option, you must sell the designated shares at the established price to the buyer if they exercise the option before it expires. When you sell a put option, you must buy the designated shares at the established price if the buyer exercises the option.
Know When (and When Not) to Sell
Certain indicators can help you decide whether selling your options make sense. You may want to sell options before the expiration date if:
- You do not expect the option to pay off and instead plan to profit by selling it and getting the premium upfront.
- The option is declining in value, and you can make another trade at a lower premium that offsets the loss.
Understanding how options are valued will also help you know when to sell options before expiration. The value of an option has two parts: its time value and its intrinsic value. To calculate the intrinsic value, find the difference between the stock’s market price and the option’s strike price. The intrinsic value changes if the market price changes.
The higher an option’s intrinsic value, the higher your potential profit (and vice versa). For example, you can command a higher price for an in-the-money option than you could for an out-of-the-money option.
The other aspect of an option’s value is its time value. You can command a higher premium price for an option that has more time before expiration than you can for an option that is about to expire. That’s because, as the expiration date approaches, the chance of the stock gaining intrinsic value goes down. This concept is called time decay.
When deciding to sell an option, you must be able to accurately evaluate both its intrinsic value and time value. You may also hear time value called extrinsic value.
You should also be able to analyze an option’s theta, which expresses its rate of time decay. As time decay gets faster, the option’s theta increases.
If you are thinking about selling an option, be sure you can accept the risk of owning the underlying asset at the strike price. Avoid entering a trade if you aren’t impressed by the market price paid for the underlying asset.
Other benefits of put selling can be exploited once this important pricing rule is satisfied. The ability to generate portfolio income sits at the top of this list because the seller keeps the entire premium if the sold put expires without exercise by the counterparty. Another key benefit is the opportunity to own the underlying security at a price below the current market price.
Await the Expiration Date
O nce you decide to sell an option before expiration, the buyer has the right to exercise it on or before the expiration date. If the option has no intrinsic value when it expires, you get to keep the premium price.
In some situations, option selling carries a higher risk. For example, if the market moves in an unexpected way, you could have a loss on your hands if you don’t have an exit plan in mind.
Avoid waiting to make a move until your options are about to expire. In most cases, options lose value more quickly as the expiration date approaches. This guide to selling options before expiration can help you learn to time these trades appropriately.