Options offer a way to put up a small amount of capital and reap enormous gains, either by betting for a security to rise in value, or making an assumption that its value will fall. These methods are respectively called ‘call’ and ‘put’ options, and traders who use this tactic can realize impressive paydays. However the losses can be equally impressive.
An investor proficient at trading using this method may want to explore selling options. Selling and writing is the same thing, and there are unique risks and rewards associated with this technique. Two types of option selling are used, called ‘covered’ and ‘naked.’ In the first, the writer of the contract is also the owner of the underlying asset. In the second, the person who writes it does not own the underlying stock, and is speculating on the direction it will take.
Smart call speculating requires extensive experience, and is not for the average investor. A safer way to sell options is to execute a ‘covered call.’ This is simply a person writing the paper for an option on stock they already own, which is a great way to generate income from their existing asset.
The reason it is a ‘covered’ call, is because the potential to lose money is buffered by the amount the option was sold for. For example, if the owner of a stock worth $100 sells a contract representing 100 shares for $3, with the belief it will rise to $105, they immediately make $300. If the price winds up at $99, they have still made money, and if it falls to $95, the loss is limited to $200.
Should the stock rise above the anticipated price, the upside is limited as well, but it is still an upside! As with trading options, the owner of the stock can also sell a ‘put,’ if they anticipate the price dropping in the near future.
The covered call strategy to sell option contracts is a conservative method of realizing a profit on a quiet stock. The investor is limiting his upside and downside potential, even though in theory they can both be significant. For the expert investor, much larger gains can be realized with the strategy of ‘naked’ option writing mentioned above.
When the contract is written for a stock that is not owned by the writer, they must have the capital to cover their position if they speculate incorrectly. For example if a naked option is written for stock in XYZ company for $100, but the stock goes on a run to $150, the writer now has to purchase shares at $150 each, and sell them to the buyer of the contract for $100. Even after factoring in the money received for selling the option, this is a significant loss.
While there are techniques to limit the risk of selling naked options, and the upside potential can be exponential, investors need a thorough knowledge of market trends before exploring this method.
Selling options are worth looking into when you plan on holding a security for an extended period of time. It offers a way to increase your income while limiting your risk, and can be more lucrative in the long run than options purchases.
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