Buying and selling stock options involves a number of strategies. Some strategies are better for certain types of stocks, and others are better for certain levels of investors. While there are many ways to choose the right strategy, ultimately, options were designed to be sold. Before you enter into the world of options trading, it is crucial to understand the terminology, how the process works, and the different strategies you can use depending on your goal and risk level. When learning how does selling options work, you should:
- Know when to buy.
- Know when to sell options.
- Understand covered and uncovered calls.
- Understand theta, intrinsic value, and extrinsic value.
How to Buy and Sell Options in Any Market
What makes options selling so appealing to many investors is that you can make money selling options no matter how the stock market is faring. Whether the market is up or down, you can always follow strategies that allow you to sell options successfully. This makes learning the strategies even more critical to success.
1. Know When to Buy
If you choose to take a bullish approach when trading options, you will buy a call when you think the stock is going to rise before the option contract expires. Buying a call can be like buying stock, though you often have more leverage than you would by simply owning shares outright. You can also do a naked call option, which requires complete accuracy in the direction.
Buying a naked put option is similar to shorting. You expect the stock to go down in price but are hoping to profit from its movement. Buying put options can be easier than shorting, as most trading companies allow it but might not be great at shorting. For this to be effective, you should expect the stock to move down or you will sustain a loss.
2. Know When to Sell
You can choose to sell a call option if you don’t think the price will reach the strike price you have chosen, meaning you don’t have confidence the stock will go up. You will need to find a buyer who believes the opposite and sell it to them. Sometimes the seller will sell a call at resistance because when it can’t break that level, it will fall. When this occurs, the seller will keep the profits, and the buyer will have a loss.
The opposite of buying put options is selling put options, which means you anticipate the stock will go up. When you sell a put, you are hoping the stock has upward motion instead of downward. You will end up taking money away from someone who had anticipated the wrong direction. Your best option for selling a put option is selling it near or at support. When the stock has no chance of breaking support, the stock will move back up, and you will make money.
Selling options is not typically as exciting as the buying process, and it is difficult to find a perfect strategy that will ensure success. It is a slow and gradual process but can be successful when navigated properly. Selling options is also an ideal way to make money trading large-cap stocks without having to pay the high price tag to buy the stocks outright. Navigating the world of selling options can seem tricky. You need to be able to take it step-by-step and understand the process fully to achieve positive results.
3. Understand Covered and Uncovered Calls
One of the most common call strategies is a covered call, where you sell the buyer the right to buy equity in the company you open. When the buyer chooses to execute the option, you must sell it to them at the strike price, even if the prices are higher or lower than your equity. With an uncovered call, you are selling the right to buy equity in a company you do not own at the time.
4. Understanding Theta, Intrinsic Value, and Extrinsic Value
Selling options can be considered a positive theta trade. This means that over time, the stock’s value will go in your favor. The option revolves around the stock’s intrinsic and extrinsic value. The stock’s intrinsic value depends on its movement, similar to home equity. When the option is deeper in the money, it typically has more intrinsic value. The extrinsic value is the time value; as the options move out of the money, the extrinsic value will rise.
When making a transaction in options, the ultimate goal is to have the stock move in a certain direction and make money off it. The trade will be responsible for both the intrinsic and extrinsic value and must make up the extrinsic value for an options trader to be profitable.
When theta is negative, the buyer can stand to lose money. Either the stock fails to move or it moves so slowly in one direction that it’s offset by time decay. Time decay can work in favor of an option seller, occurring each business day and even over weekends. It can be a moneymaker for many investors, albeit often a slow-moving one.
5. Know the Risks and Rewards
A stock option can be favorable if it stays in the same area for a long time or moves in your favor. But to be truly successful, you will need to focus on implied volatility changes. Implied volatility, also known as vega, will increase or decrease depending on the supply and demand of options contracts.
If options sellers find themselves falling short on a contract and there is a sudden demand for that contract, the price will be inflated and they might experience a loss even if the stock has had no movement. Typically, in the case of a single stock, inflation occurs in connection with an earnings announcement. As long as an options trader stays on top of volatility, the seller will have an edge, as the price should eventually return to average.
Time decay can also work in the seller’s favor. One crucial thing to remember is that as the strike price gets closer to the stock price, it will become more sensitive to vega.
What Is Your Probability of Success When Selling Options?
A contract’s delta helps determine whether the value of the option contract will increase if the stock moves in favor of the contract. Many sellers use it to determine their probability of success.
For example, if a delta has a 1.0 means, the dollar-per-dollar amount will likely move with the underlying stock. When the delta has a .50 means, then it will move at 50 cents on the dollar with the underlying stock. This can translate to a 100% probability there will be at least a cent in the money by the time the option expires with a delta 1.0 means and a 50% chance of one cent in the money with a delta of .50 means. The further out of the money the option, the greater the probability of success.
Sellers also have to determine how important the probability of success is when they compare it to the premium they will get by selling the option.
What Are the Worst-Case Scenarios When Selling Options?
Many investors won’t sell options out of fear of facing the worst-case outcomes. While worst-case scenarios rarely occur, knowing about them can help you prevent financial disaster. When you sell a call option, you risk the stock climbing exponentially. This is unlikely, but if it does occur, there is no protection to stop the loss from occurring. Thus, it is vital for call sellers to set points when they want to buy back the option if the stock continues to climb. This can help them hedge the loss.
When you are selling puts, the risk is the opposite, and the worst-case scenario can occur when the stock starts to plummet. The only good news here is that the stock can only fall as far as zero, so at worst, you will be left with the premium. You will basically be owning a covered call. You can protect yourself when selling puts the same way: by determining the price you will choose to buy back.
If you want to learn more about how to be successful at selling options or to get more information on starting investing, download our free e-book, or sign up for one of our investing webinars.