Writing Options is not something that most investors think of when it comes to investing strategies. It's probably because the last thing that comes to their mind is stock options.
Most dismiss them as too risky.
That's mostly because the typical risk tolerance of the average investor is nowhere near the same zip code as the active options trader.
Also, there is no shortage of information relating to the risks associated with stock options, so the average investor is very likely to shy away from options trading altogether.
When you hear the term, "writing options" it refers to selling stock options as opposed to buying stock options.
So selling is called "writing" in the world of options trading.
I know, it would be much simpler to just say selling, but as always, the financial community has to complicate things.
There are two styles or methods of writing options:
For every call or put option contract that is purchased on the open market, there is a corresponding sale of that same contract. In other words, someone had to "write" or sell the contract to the buyer in the first place.
If you own a stock that also has listed stock options, that someone could be you, even if you are indeed a conventional, risk-adverse investor.
Selling options against shares you own is called writing covered call options.
Covered calls are sold by investors that own shares of a particular stock who are interested in collecting the "premium" that writing options will add to their portfolio.
For example: a buy and hold investor who owns 300 shares of ABC company worth $50 per share might decide he'd like to collect a nice "dividend" on those shares by writing options against them.
So when you are selling stock options to someone, you are giving them the "right" to purchase stock from you. In exchange for selling these "rights," the buyer is going to pay you money.
This money is yours to keep no matter what happens in the future. If the option doesn't get exercised, you get to keep the money you were paid for selling the option.
While you don't have to actually own a stock to consider writing options against it, doing so carries a great deal of risk compared to writing options against a stock you already own.
Selling someone a stock option without owning the underlying stock is called a "naked" position, since if the option contract is eventually exercised, you will have to purchase the stock at market price in order to sell shares to the option contract holder or buyer.
And if the price of those shares runs counter to your predictions about the market's trend, you may find yourself swallowing significant losses.
Investors who engage in naked option selling should become very familiar with option greeks. The best option sellers are usually those who have a thorough understanding of how to best utilize option greeks.
Selling naked stock options is the riskiest, but also the most profitable form of option selling. In theory, you just sit back and sell stock options and collect money month in and month out. You never have to worry about tying up a lot of cash to buy the stock.
For example: an investor believes that ABC company worth $50 per share is going to go down in price in the near future. He might decide he'd like to collect some easy money by selling stock options.
He finds the perfect stock option to sell and he sells 5 contracts for $1.50 ($150) giving him a profit of $750 (excluding broker commissions).
That's it! No stock to buy and no other options to buy. The only cost to you is your broker commissions. That's the good part of the equation.
The bad part of the equation is the unlimited risk you took.
If the stock suddenly rose in value to $80 the option buyer would most likely exercise their contract so you'd be forced to buy the stock for $80 and then would have to sell it to the buyer for significantly less (whatever the strike price was).
There is no limit to how high a stock can go, hence the unlimited risk. You would most likely buy back your contract before this happens, but still the risk is there and needs to be respected.
For conservative buy and hold investors, writing options against shares they own provides an excellent opportunity to realize gains without necessarily having to sell the stock shares themselves.
For the aggressive investor, writing options can be a very lucrative opportunity if you manage the risk properly.
Whether you are a periodic speculator or a micromanager of your own retirement portfolio, don't dismiss the idea of selling stock options. You may indeed find the returns attractive, even if your risk profile is as cautious as they come.
Module 3: Basic Strategies