Stock options tend to lose value as they approach their expiration. Therefore, it works in your favor when you sell options short instead of buying them. You profit from premium decay when you sell options short. I’ll show you how it's done.
Stock options tend to lose value as they approach their expiration. Therefore, it works in your favor when you sell options short. It works like this:
However, someone sold them that option. It could have been you. Since options tend to lose value, you could be on the winning side! It's best to be the option seller (or option writer, as it's called).
Instead of buying options, you sell them. You become the option writer, and the decaying time premium works in your favor. Any stock options broker will allow you to do this.
"Writing an option" is the term used for selling an option you don't own. It's also known as selling short.2
How do you write an option? You sell it in your brokerage account just like you buy and sell stocks. When you write an option, you indicate an order to "sell to open." That is because you are opening the transaction.
It's merely making the trade backward—selling first and buying back later, hopefully at a lower price.
Taking Your Profits
Eventually, you will have to repurchase the option to close the trade. That's done with a "buy to close" order. But you don't always have to repurchase it.
If the underlying stock never trades above the option's strike price (known as out-of-the-money), the option expires worthless. In that case, you don't need to repurchase it. Instead, you just let it expire and keep all the money you got for it.
I don't recommend waiting for it expire. Since options tend to lose value over time, you could have the opportunity to repurchase them for less than you sold them for at any time. The difference is your profit.
There are two reasons not to wait:
There are two kinds of options. A "put" and a "call." With this strategy, you will sell, not buy, these options. Again, you are writing the option.3
The following is what selling a put or a call means:
Options have expiration dates from one day to several years. I like to write 30-day options. The time premium decays quickly in the last 30 days. That works in your favor when you sell short.
You receive a credit to your account for the premium the buyer paid for the option you sold. And when you close the trade by buying it back, the difference (due to the decay) is your profit.
There are three ways to trade with these strategies:
Don't worry if that is unclear at the moment. I realize there is a lot to absorb, and I'll explain all three of these techniques in detail in the following sections.
If you already own a particular stock and don't think it's going to move much in the next 30 days, you can squeeze some extra money out of it by selling someone a 30-day call option on that stock. That is known as a covered call.4
What Are the Pros and Cons of Short Selling Call Options
Shorting an option is when you sell first and buy it back later, or let it expire worthless. If you buy it back, the idea is to close the trade by purchasing it at a lower price. Therefore, you keep the difference as the profit.
You are selling the right to "call" the stock away from you at the agreed price. That is why it's considered a call option. You receive a credit to your account for the premium the buyer pays.
If the stock price drops or remains the same for 30 days, the option expires worthless, and you keep the money you received when you sold it.
You're probably thinking, "But I lost money on the stock I own!"
The extra money you kept from the expired call option lowers the stock's cost-bases. You still have the shares, and the stock price can increase again (if it's a good company).
What Can Go Wrong When Selling Covered Call Options?
When you own the underlying stock for the option you sell, you are covered in case the price goes higher than the option's strike price.
However, in that case, your shares will be called away from you. That is because the option buyer exercises their right to buy your shares at the agreed price, even though they may be worth more than that now.
Remember, you only do this with a stock you think will not move much in 30 days. And if it does, you'll receive more for it than it was worth when you entered the trade because you'd be selling it at the option's strike price. You also keep the premium the buyer paid for the option.
What's the Worst Case?
If the stock shoots unusually high, you are forced to sell it at the agreed option strike price. You’d miss that tremendous gain, but you still keep the money received for selling the option.
That's another reason for selling options that expire within 30 days. The chances are slimmer for a stock to make a big move in that short time period. But it can happen.
What if you'd like to buy a stock but don't want to wait for a better price? In that case, you could sell a 30-day put option to buy the stock at a price you'd want to pay. That means you are selling someone the right to sell you their shares at that price—the option's strike price.
What Are the Pros and Cons of Short Selling Put Options
Two things can happen:
If the stock falls as in the first scenario, the option buyer will exercise their right to sell their shares of the underlying stock to you.
You would have to buy the stock at a price agreed to based on the option's strike price. You were not protected against that outcome. We refer to that as a "naked put" for that reason.5
What Can Go Wrong When Selling Naked Put Options?
Remember that you would be doing this only because you would like to buy the stock anyway. You never want to sell a put option if you are not willing (or able) to buy the stock.
You will need to have enough money in your brokerage account to buy the shares in case the buyer of the option "puts" the shares to you.
If the stock price goes down, the option buyer will sell you their stock at the agreed strike price. Of course, that is higher than it's selling for on the market, and you have to buy it anyway.
That is why I said only to sell put options when you want to buy the stock anyway. You may end up buying the stock if you are wrong with the timing or the price.
That's not bad because you get stock at a lower price than if you had bought it when you first considered buying it.
Why is that? Because the put option you sold was an offer to sell you the stock at a lower price than its current market price. You agreed to buy the stock at that price if it goes below that strike price by the expiration date.
So, you bought the stock at a better price anyway. In effect, you paid that much less for the stock. The premium you received when you sold the option reduces the cost basis by that amount.
So it wasn't really a bad thing since you intended to buy the stock anyway.
What's the Worst Case?
If the stock price goes extremely low, you still have to buy it at the strike price. That's not such a great deal because it is worth so much less on the market.
But remember: You did this only when you wanted to buy the stock anyway. Therefore, you're still better off than if you just purchased the shares originally. That's because you also have the profit from the sale of the option, keeping all the premium received.
Alternatively, if you see an options trade going against you and change your mind about buying the stock, you can close the trade early by buying back the option.
Since options tend to lose value as they approach expiration, you could likely buy back the option at a lower price even if the stock started going against you, as long as it didn't go too far to an extreme.
Options indeed lose their premium value over time, and now you know how to make this work in your favor. But that is only safe if you are covered by having the shares available to sell if a call option goes against you, or you have the funds available to buy the stock if a put option goes against you.
If you only want to work with options and not consider having shares of stock called from you or put to you, you'll need a strategy to protect you from a worst-case scenario.
You can do that by buying a low-cost option to limit your risk of the short sale with the higher-priced option. We call that a vertical trade.
Using Vertical Trades to Limit Your Risk for Protection
To limit your risk, you buy (long) a further out-of-the-money option at the same time as when you sell (short) for the premium in another option.
For example, let's say you sell a call option to sell XYZ at $50. You can purchase a call option to buy the same stock at $60. That is called a vertical trade. Traders use the term "defining your risk."
You will pay less for the $60 call than you got for the $50 call, so you'll have a credit on the trade. The maximum risk is the difference between the two strike prices.
You still have to sell the underlying stock at $50 if it goes over that price, but no matter how high it goes, you can always exercise your right to buy the same shares at $60. So $10 is your total risk if this trade goes against you. See how that works?
You had protected yourself with a spread by short-selling a high-premium option and buying (long) an option at a lower cost.
Markets can change quickly, and a profitable position can suddenly turn against you. You never know when some unexpected world event can occur that turns a winner into a loser.
The best strategy is to manage your trades by closing positions when you have a 50% profit. Since options lose value as they approach expiration, gaining such a profit can be expected even if the underlying stock doesn't move much.
Of course, the decaying premium may leave you a bigger profit later in the period before expiration. But why chance it? Prices fluctuate, and it's best not to be greedy—hoping the options will expire worthless. Instead, when you have reached 50% profit, take it.
Another reason for taking that 50% profit when you have it is that you can only achieve another 50% gain. But when you close that trade, you can open a new trade with a chance for a more considerable profit and with no additional risk.
Sure, you could enter an additional trade, but then you'd be doubling your risk. So even though you would be using vertical trades to limit your risk, you wouldn't want to extend that beyond your means. So, take your profits on trades that achieve 50% gain and start a new one for greater credit.
How to Close a Vertical Options Position Before Expiration
You can close that position by simply buying the short option and selling the long option simultaneously. Most brokers let you set up that trade in a single click through their platform.
If your broker doesn't include that capability, consider switching to another broker that fully supports options trading.
When you sell options (as an option writer), you can create a consistent revenue stream.
Remember, it’s best to keep the trades limited to a 30-day expiration because that’s when options decay the fastest. And you want the option you sell to decay in value, so you keep the difference as profit.
With the risk control strategies I discussed, and trading only as an options writer and not as a buyer, you'll be on the winning side with the odds in your favor.
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