Chapter 2-2 Single-Leg Short Strategies

Single-leg short strategies are relatively basic options strategies that involve selling options rather than buying them.  For every transaction there is a buyer and a seller.  In the case of options, the seller of an option who does not already own it is known as the option writer.  In many ways the option writer is similar to the short seller of a stock although there are several key differences that must be considered before beginning to write options.  The following section will cover the risks and rewards associated with option selling and provide examples to aid your understanding.

Selling Calls

Interested in generating income?  When option premiums are high (that is, when implied volatility is high), some traders turn to selling options.  Selling “naked” calls, so called because you do not own the underlying shares as a hedge against the case in which you are assigned, is a neutral to bearish strategy.  You want the market price to be below the strike price of the call that you sold at expiration so that the option expires worthless.  Selling calls should be done when you expect the underlying stock to fall or stay flat.  Option buyers have rights, option sellers, however, have obligations.  By selling calls, you are obligating yourself to selling the stock at the strike price when you are assigned.  Assignment is the other side of an option being exercised.  If a call buyer decides to exercise the long call that exercise is assigned randomly to a seller, any seller, of that call, and that individual is obligated to sell stock to the call buyer.

If you do not own the shares of the stock when assigned you will have to come up with them.  This is the reason that brokerages require a margin account for individuals who wish to sell naked calls.  It is also the reason that selling calls is considered the options strategy with the highest risk.  Stocks can go up infinitely and thus the risk of a naked call is unlimited.  Naked calls are the strategy that gives options a bad name among the risk averse.

By way of explanation, let’s say you sold the GOOG 500 call option for $25 when GOOG was trading for $500.  If GOOG is anywhere below 500 at expiration, then you keep your credit of $25.  If the stock goes up to $525 you will be assigned at expiration, but will come out flat since you already pocketed a credit of $25.  However, as the stock price continues upward your losses mount.

Consider the following table to help clarify the risk and reward of selling call options:

 

GOOG

Stock Profits/Losses

% Return

Call Profits/Losses

$300

-$200

40%

$25

$500

$0

0%

$25

$550

$50

10%

-$25

$700

$200

40%

-$175

This can be shown graphically:

option-content-image-2-2-1

Because of this unlimited risk as the underlying stock price rises selling calls is rarely done in isolation.  In fact, selling calls against stock that you own, known as “covered calls” or “buy-writes,” is considered the most conservative options strategy. (Covered Calls is explained in much greater detail in a latter lesson.)

 

 

Selling Puts

Want to be paid to buy stock? Many stock investors use “limit orders” to enter into long positions.  Another way to buy stock for less than the current market price is an options strategy called cash secured puts.  The strategy is so named because “cash secured” means that you have the cash in your account readily available to buy the stock at the designated strike price.  To maximize its effectiveness, selling puts is usually done with options that have a high implied volatility.

This is a neutral to bullish strategy which can be used to either generate income or to enter long stock positions at a discount to the current market price.  By selling puts you are obligating yourself to buy the stock when assigned.  This strategy brings income into your account because you are paid the premium upfront; you will keep 100% of this income if the stock closes above the strike price at expiration.  Traders sell puts if they think the stock is going to stay flat or go up slightly.  However, this should only be done if they are ready and willing to buy the stock if assigned.  To this effect, selling puts can be an excellent way to initiate long stock positions while getting paid to do so.

For example, let’s say you sold the GOOG 500 put option for $25 when the stock was trading for $500.  If GOOG is anywhere above 500 at expiration you will keep your entire credit of $25.  If the stock is below $500 you will be assigned, and you will be obligated to purchase the stock at the strike price.  Additionally, the combined trade itself is profitable until $475 (known as the break-even price, this is simply the difference between the strike price and the collected premium) since you have previously pocketed the $25 credit.

Consider the following table to help clarify the risk and reward of selling put options:

 

GOOG

Stock Profits/Losses

% Return

Put Profits/Losses

$300

-$200

-40%

-$175

$450

$0

0%

-$25

$500

$50

10%

$25

$700

$200

40%

$25

This can be shown graphically:

option-content-image-2-2-2

In summary, puts can be sold cash-secured or naked.  They are cash secured if you have the cash readily available in your account to purchase the stock at the strike price if assigned.  If cash is not readily available then sold puts are considered naked, and a lower margin is required.  This has the effect of increasing the return on margin, but also increases the potential risk.

Exiting Short Positions

When an option has been sold, the position can be closed in one of three ways:

  • Buying back the option – After an option has been sold it can be bought back at any time, similar to covering a short-sold stock position.  This is done when the option seller wants to avoid the risk of assignment (for example, if you sold a call and the stock went through your strike).  If you do not want to be assigned, and therefore forced to sell the stock, you can buy back the option to close the position.  Your profit or loss will be based on the difference between the premium paid and the premium received.
  • Letting it expire – If the option gets all the way to expiration it will expire.  The option will expire worthless if it is out of the money.  Typically, this is what you want to have happen when you have written an option.  If the option is in the money by at least $.01 it will be automatically exercised and you will be assigned, automatically selling the stock if you were short a call or buying the stock if you were short a put.
  • Assignment – American-style options (all equity and ETF options) can be exercised at any time before expiration.  As a result, you could be assigned at any time after you have sold an option.  Most traders view this as a negative, but it is not necessarily so.  If you are using cash-secured puts to acquire stock then assignment means you have achieved your objective at a below-market price, and thus met the objective of the strategy.

Rules of Selling

Selling options is best done when implied volatilities are elevated and expected to fall.  This makes sense because higher implied volatilities carry higher premiums and thus brings in more premium income to your account.  However, it is extremely important to remember that selling options involves considerable risk, and high implied volatility can always go higher.  Since we already know that time decay is greatest in the last 30 to 45 days, this is typically the best time to sell options.  In this scenario, the ideal result is to have the options expire worthless, and we are not interested in buying back the options unless absolutely necessary.

Writing options allows investors to profit from sideways markets by selling options and generating income.

Example:         You own 100 shares of General Electric (GE).  With the stock at $34, you sell one GE 35 call for $1.00.  If the stock remains at $34 on the expiration date, the option will expire worthless and you have earned a 3% return on your holdings in a flat market.

Options make it possible to get paid to buy stock.

Example:         Apple (AAPL) is trading for $175, a price you like as a long entry.  You sell an at-the-money put for $9.  If the stock is below $175 at expiration you will be assigned and have essentially purchased the shares for $166.

Options can be used to hedge against risk and protect positions or portfolios.

Example:         You own 100 shares of AAPL at $190 and want to protect your position so you buy a 175 put for $1.  Should the stock drop to $120, you are protected dollar for dollar from $174 (the strike price plus the $1 you paid for the put) down, and your loss is limited to $16 as opposed to $70.

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