Selling Options Explained



selling-optionsSelling an options contract, also know as writing an options contract, is essentially an agreement to sell the options buyer the “option” to purchase an underlying stock at a predetermined value (the strike price). When you agree to sell the option the buyer pays you a fee for doing so, this is called the options premium.

An equity options contract actually consists of 100 shares in the underlying stock. So if you were to sell a Google (GOOG) May 50 Call, you’re selling the buyer the option to purchase 100 GOOG shares at $50 before the end of May.

The buyer is under no obligation to purchase these shares at that price. But even if he doesn’t exercise the option you still get to keep the options premium for your trouble.

Puts and Calls

There are essentially two different types of option that you can sell (write), calls and puts. If you sell a call option the buyer is hoping that the price of the underlying asset will go up and if he buys a put option he’s hoping that the price will go down.

You on the other hand are hoping for the opposite. If you sell a put option you’re hoping the price will rise, since you’ll be able to sell the stock for more than you paid for it and you’ll still profit from the premium you received for selling the put to the buyer.  

Writing a Put

You would write (sell) a put if you thought that the price of an underlying asset was heading for a rise. Please note that you don’t have to already own the underlying stock but you’ll need enough money in your account to cover the purchase of the stock should your option get exercised.

Let’s say Google (GOOG) is trading at $50 in May. You think the price is undervalued so you write (sell) a June 50 put option to the option buyer for a $100 premium.

He pays you $100 and hopes that the price will fall; you receive the $100 and hope the price will rise.

By the end of June GOOG has in fact risen and is trading at $55. You can now sell your shares for $5500 making a profit of $500 over the purchase price, plus the options premium of $100, making a total profit of $600 for the trade.

Of course you don’t have to wait for the option to expire; you can exit the trade at anytime by selling it back to your broker. 99% of all options traded never make it to expiry.

Writing a Call

You would write (sell) a call option if you thought the price of the underlying asset was going to fall. You’re selling to the option buyer who’s hoping that the price will rise. The buyer gives you a small premium to hold the stock until expiry. Once again you don’t have to actually own the shares you’re selling.

Let’s look at our Google example again. Google (GOOG) is trading at $50 in May. You decide that this is overvalued and heading for a fall, so you sell a JUN 50 call for $200. The option buyer pays you $200 and hopes that you’re wrong and the price will rise.

Come the end of June GOOG has risen to $55 so you were wrong. If the options buyer chooses to exercise the option you have to sell him the stock at $50 which he will sell on for $55.

But you’ve not lost, because you essentially sold the stock for the same amount you purchased it for and you still get to keep the $200 option premium. In effect you’ve made a $200 profit, less any commission.

Please note that all the above examples exclude broker commissions. When you make an options trade for real you’ll have to pay a small commission for the privilege. The amount you pay varies from broker to broker but it shouldn’t be more than $10 or $20.

When you get a little more experience and start trading more complex option strategies that involve 3 or more individual contracts, you should think about moving to a broker that specializes in frequent trading. OptionsHouse are a good example as they offer trades starting at $0.15 per contract (+$8.95 per trade).

Conclusion

Hopefully this article explains how simple options really are. They can seem a little daunting at first, but once you’ve got you’re head around the terminology there’s really nothing to be scared of.

However there really is no substitute for practice when it comes to trading options. With this in mind you need to be careful about which broker you choose when starting out. Don’t make the mistake of choosing the cheapest broker you can find, you need to learn as much as you can about the different strategies available.

So look for a broker that offers excellent training tutorials and seminars. These will more than compensate for cheaper trading fees in the long run, our favorite broker for beginners is optionsXpress. In the beginning training is everything, always remember the words of Master Yoda “Much to learn, you still have“.




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