Swing Trading Options - Part 2
11/18/2015 8:00 am EST
The trader selling options is collecting its price as a premium, writes Markus Heitkoetter of Rockwell Trading, and he's hoping they expire worthless so he can keep the premium.
In my previous blog post we talked about buying options. Here, we will discuss why some traders prefer to sell options, and review two basic strategies for selling options.
As discussed in the previous blog post, the buyer of an option has to pay the price of the option. When selling options, the trader is collecting the price of the option as a premium. He then hopes, that the option expires worthless so that he can keep the premium.
Here's an example:
As I am writing this blog post, AAPL is trading at $440. Let's assume you are bullish on AAPL and expect the stock to move higher. There are 18 days until options expiration. You look at the chart and think that AAPL won't move lower than $425. Therefore you decide to sell a put option with a strike price of $425. The put option is trading at $5.00, and since one option contract represents 100 shares of the underlying stock or ETF, you are collecting $5 * 100 = $500 in premium.
The money is deposited into your trading account, and if AAPL closed above $425 in 18 days from now, you can keep the money.
Differences Between Buying And Selling Options
Here are the main differences between buying and selling options:
As time decay is working against the buyer of an option, it is working in favor for the option seller.
In the example above, the entire $5.00 is known as extrinsic value. This means that this premium is priced based on the possibility that the stock might move below $425. However, since the stock is currently trading at $440, there is no intrinsic or real value priced into the option (this would change if the stock was trading below the strike price of $425). The price of the option will decrease as AAPL moves higher, and we get closer to the option's expiration.
The buyer of an option has limited risk, but the seller of an option has unlimited risk.
If AAPL moves lower than $425, the seller of the option has to pay the difference between the strike price of $425 and the price of the stock on expiration day, if he is still holding the option. If AAPL trades at $400 on option expiration, the seller of an option has to pay ($425 - $400) * 100 = $2,500.
There are strategies to protect yourself and limit your risk. We will talk about these strategies in the next blog post.
Here are the two main reasons why a trader considers selling options:
Reason 1 for Selling Options: Covered Calls
The most popular strategy for selling options is known as a covered call. Covered calls are popular because traders can collect option premium using stock that they already own as collateral.
NEXT PAGE: Another Reason to Sell Options|pagebreak|
Here's an example:
Let's say you own 100 APPL stocks that you bought at $425. AAPL is trading at $440 now, and you decide to sell a call option with a strike price of $465 and 18 days left to expiration.
The price of the option is $2.03, and you are collecting $2.03 * 100 = $203 for selling the $465 call option.
If AAPL is trading below $465 on expiration date, you would keep the premium of $203.
If AAPL is trading above $465, then you have to deliver; your AAPL shares, and you have to sell them for $465, regardless of the current price of AAPL. If AAPL is trading at $470, you still would only get $465 per share. So you are missing out on an additional $500 in profits, but these missed profits are partially offset by the $203 you collected in premium.
And you are still making money on the stock, since you bought them for $425 and sold them for $465.
The main advantage of this strategy is that you are collecting premium if the price of the stock stays below the strike price you selected. So you would still make money on the shares that you own even if stock price drops or moves just sideways.
Reason 2 for Selling Options: Collecting Premium
You could just sell options even without owning the stock. If you are conservative and sell options with several strike prices out. In this case, you collect less premium, but the chance that the stock moves above or below your strike price until expiration is smaller.
The put option with a strike price of $400 is selling for $1.38, and if you decide to sell this option, then you would get $138 per option contract. Yes, that's only 25% of the premium that you would get for an option with a strike price of $425, but it's less likely that AAPL will drop to $400 in the next 18 days than a drop to $425.
And, of course, you don't have to wait until the expiration day. You can always buy back the option before it expires. Time decay will work in your favor.
You can measure the time decay by looking at the theta of an option. In our example, the theta is $0.14. This means that you can expect the option price to drop $0.14 per day if AAPL keeps trading at $440. And, of course, the price of the option will decrease if AAPL is trading higher.
Therefore, it could be possible to buy back the option that you sold after a few days for maybe $0.50. In this case, you would keep ($1.38 - $0.50) * 100 = $88.
Of course, you could trade multiple option contracts and therefore increase your return, but keep in mind that when selling options you have unlimited risk, unless you apply some of the strategies that we will cover next time.
In the next blog post, we will talk about combining buying and selling options, and talk about strategies like: vertical spreads, straddles and strangles, iron condors, and butterflies.
By Markus Heitkoetter, Founder and CEO, Rockwell Trading