Selling Options

Hello Everyone,

Thank you for all for all of the great response from my last post about options. As promised today I am going to explain to you how selling options works.

The first thing you need to know in order to understand selling options is the concept of premium. Remember in my last post when I explained that when you buy an option you have to pay for the right to buy or sell the underlying security at a future date at that specific price. That amount you pay is called premium. Selling options is also known as "writing options" or "premium harvesting".

I think that the best analogy to use to explain how selling options works is insurance. Today I am going to explain selling put options... When you buy car insurance you pay a monthly premium, and if you ever get in a car accident the insurance company pays you a lump sum to cover your costs. When you sell put options you are acting as the insurance company. Someone in the market place, we will call him Bob, believes that the market is going lower and wants to BUY a put to "insure" against the possible losses. You, as the seller, believe that the market is not going to go down, and therefore are willing to act as the "insurance" against the market going down. You are going to sell Bob a put option (his insurance against stock losses).

Let's put some numbers to this... today Google stock (GOOG) is at 679. Bob can only stand a 5% loss in one week, therefore he wants to buy a put option 5% below the current stock price with a strike of 645 (679*.95= 645). This way if Google drops more than 5% in one week the put option will pay off, protecting him against the losses. You on the other hand do not believe that Google stock will drop more than 5% in one week and are therefore willing to assume the risk on the other side of Bob's trade (act as the insurance company). You sell him the 645 one week put option on Google stock and you collect $70 in premium. As long as Google stock does not drop below 645 in one week you get to keep your $70. If the stock does drop below 645 then you must pay out the value of the put to Bob at the end of the week, which in theory could be any amount depending on how much the stock drops. Therefore in this trade I just explained you have an unlimited loss potential. However because the probably of Google stock dropping more than 5% in one week is so low, you are will to take on this risk to make your premium. This is known as high-prop trading.

One key difference between buying a put and selling a put is that when you buy an option you have the "right" or the "option" to exercise your put. When you sell an option you are obligated to deliver your pay out. Therefore in this example you could make $70 per contract in an instant as long as you think that Google stock will not drop more than 5% in one week.

I will let you think about this a little before I move on to more complex option trades, and explain to you how you can mitigate the unlimited loss potential described above.

Good bye for now,

Breana