Understand the risks before selling options.
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When most people first learn about options, itâs in the context of buying call and put options to speculate on the direction of (or hedge a position in) an underlying stock, exchange-traded fund (ETF), or other security (called âthe underlyingâ in trader jargon). The option contract gives you the right, but not the obligation, to take a long or short position in the underlying security. You paid a premium for that right.
But did you know you can flip this idea on its head, and instead of paying a premium to buy an option, you can collect the premium by selling options? Thatâs right: you can have the premium deposited directly to your brokerage account the same day.
Key Points
- When selling an option contract, you take in premium up front, but your risks can be substantial.
- Because a stock or other security could theoretically rise to infinity, many brokers prohibit selling uncovered or ânakedâ calls.
- Option selling can be part of an income generation or stock accumulation strategy.
But thereâs a catch. When you buy an option, you pay for the right to decide when to exercise it, but you have no obligation to do so. When you sell an option, you give away the right to decide, and you accept an obligation. Thatâs the trade-off.
- Selling put options. You collect the premium, but you may have the obligation to buy the underlying at the strike price if it trades below that price at or before expiration. Selling puts can be part of a strategy to accumulate shares.
- Selling call options. Once again you collect the premium, but you may be obligated to sell the underlying at the strike price if it trades above the strike price at or before expiration. If you own shares of a stock or ETF, selling call options could be part of a viable income-generating strategy known as a covered call.
The risks in selling uncovered calls and puts
Selling uncovered calls. The term âuncoveredâ simply means youâre selling a call option contract thatâs not covered by a position in the underlying security. Itâs also known as a ânakedâ short call option. This strategy is considered very high risk, as youâre theoretically exposed to unlimited losses. Thatâs because thereâs really no limit to how high a stock can rise.
Suppose a company makes a big announcementâa takeover, a new product thatâs going to change the world, or a major government contractâafter market hours. If you held a naked short call position, your losses could be substantial. The holder of the call option would exercise the option, meaning you would be âassignedâ a short position at a price much lower than where the stock is trading (see the risk graph for a short call option).
Risk graph for a short call option.
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Breaking down the short call strategy:
- This is a neutral to bearish position. If the underlying falls in priceâand even if it sits stillâyouâll collect the premium, but you wonât be assigned a short position.
- Your profit is defined by the premium you collect. Your risk is unlimited. If the underlying security is in-the-money (meaning the underlying is trading higher than the strike price) at expiration, youâll be assigned a short position. For standard equity (stock) options, each contract is exercised into 100 shares.
Multipliers and contract terms
Different securities (stocks, stock indexes, ETFs, futures) have different option contract sizes and delivery terms.
- The naked short call strategy can only be executed in a margin account. You would need substantial margin cash on hand and special permission from your broker. The margin requirements are fluid and may changeâsometimes dailyâduring an optionâs life.
- Risk management is key. Keep a close eye on the price of the underlying, and consider putting a stop-loss order in place to help limit your risk if a trade is going against you.
- One popular strategy involving call selling is the covered call, where you sell call options against stocks you own. Itâs a way to potentially earn income from stocks you own, but if the stock price rises above your strike price, your stock might get âcalled away.â
Selling uncovered puts. In exchange for collecting a premium, the uncovered ânakedâ put seller accepts the obligation to buy the underlying security at the strike price until the optionâs expiration date. The position is considered uncovered if you donât have any corresponding short exposure in the underlyingâeither through a short position in the security or a long put position in another strike, for example.
The naked short put is also a high-risk position, but technically slightly less risky than a naked short call. Thatâs because in a worst-case scenario, a stock can only fall to zero, but could rise to infinity (see the risk graph for short puts).
Figure 1: SELLING PUTS FOR STOCK ACCUMULATION. With the stock at $50, if you sell a 45-strike cash-secured put for $2, youâll be assigned a long position of 100 shares at $45 if the stock falls below that price. But because you took in $2 of premium, youâre essentially acquiring the stock at $43. If the stock stays above the strike, you pocket the $2 premium and have no position in the stock. For educational purposes only.
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Breaking down the short put strategy:
- This a neutral to bullish position. If the underlying rises in priceâor even if it sits stillâyouâll collect the premium, but you wonât be assigned a long position.
- Just like with the short call, your maximum profit on a short put is defined by the premium you collect. The risk is substantial.
- Some traders sell naked out-of-the-money puts on stocks theyâd like to own at a certain price. They choose a strike price at or below their target. For example, if a stock is trading at $100, and youâd like to buy it if it ever gets down to $90, you could sell the 90-strike put. If the stock doesnât get down to $90, you pocket the premium. If it does, youâre assigned a long position at a price where youâd like to buy anyway. This is called an âaccumulationâ strategy.
- Youâll need special permission from your broker to sell uncovered puts. For basic-tier margin accounts, the broker will require enough cash to purchase the underlying if youâre assigned (this is known as a âcash-securedâ put). For example, to sell a 90-strike put, you might be required to keep enough ready cash to buy 100 shares at $90 per share, or $9,000.
Discover option strategies and spreads for protection, speculation, direction, and volatility with our interactive guide.
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Insurance companies are put sellers
Everyday life is full of options. One example thatâs familiar to us is insurance companies. If you have car insurance, you know that every year, you pay a premium for coverage. That coverage is a put option, and the insurance company is the seller.
The insurance company collects the premium and hopes youâll never have to submit a claim. If you do submit a claim, itâs essentially an in-the-money put option that you âexercised.â Your insurance company was âassignedâ this option and has an obligation to pay.
Insurance companies love claims-free drivers. A no-claim year is a put option that expires out of the money (i.e., worthless), and thus the insurance company keeps the full profit on the put option they sold to you.
Selling options puts the premium in your pocket up front, but it exposes you to riskâpotentially substantial riskâif the market moves against you. Some brokers may not allow you to sell naked short calls, and put selling might be limited to the cash-secured variety.
But thereâs a way to collect premium up front, give yourself a bearish or bullish bias, and limit your risk. Itâs called a vertical spread, and if youâre ready to take your options knowledge to the next level, itâs a great place to start.
This article was most recently revised and updated by John Manley, DMSThis article was most recently revised and updated by Doug Ashburn
