Most of us have seen or heard of the movie The Big Short, which tells the story of the 2008 subprime mortgage crisis. Michael Burry was an obscure investor made famous when he bet against big banks by short-selling (shorting) the stock. His high-risk gamble paid off when Lehman Brothers filed for Bankruptcy and many failing banks had to take government assistance. Financial regulators have made shorting stocks impossible for everyday investors due to the extreme risk involved. However, it is possible for us to channel our inner Michael Burry and short sell options. Let's learn about the different ways possible to sell an options contract.
Selling an option
Closing an option position
The most common sell order for options is a sell-to-close order.
We can cash in on the increased value of our option contract by closing the contract. A new buyer will purchase our contract and will pay us the market price for our option. Immediately after we sell our contract, the contractual agreement we had previously with the investor who sold the contract to us will be transferred to the new buyer. We can also sell-to-cover to cut our losses early in a losing position. To properly close out a position, the exact option contract must be sold. The underlying stock, the strike price, and the maturity of the contract being sold must match the call contract that was purchased.
Capital gains tax
Upon closing out a contract for a profit, it's very likely we will owe short-term capital gains.
We'll need to expect and prepare for a higher tax rate after closing our options position. It's very rare for options contracts to be held over a year due to maturities and theta decay, a topic we'll cover in future lessons. Most people who trade options pay income tax on the gains in their options positions.
But what happens if we end up selling a call option without having bought one?
Writing an option/ shorting an option
Selling a call option contract without an existing open position means we are writing the options contract or short an option.
As the seller, we:
- Select the underlying stock that the contract covers
- Pick a maturity date standardized by the exchange that binds the contract
- Select the strike price for the contract
- Collect the premium from the buyer
- Are contractually obligated to the buyer of the option to sell or buy the stock at the strike price
The risk involving shorting options is that the option ends in-the-money and we are assigned.
Not all options are the same. The amount of risk taken when shorting a call option is significantly higher than if we shorted a put option. By shorting a call option, we lose more money as the stock price increases—in theory, the increased risk for shorting a call is infinite since there is no limit to how high a stock price can increase. The idea of an infinite stock price is only theoretical and not very practical. Let's take a look at an example of shorting a call during a massive jump in a stock's price.
When we short a put option, we lose money when the stock price drops. The worst-case scenario for shorting a put is needing to buy the underlying stock at the strike price when the stock price has dropped to $0. While this is extremely unlikely, our losses cannot increase further since the price of a stock cannot be negative. The most we have at risk is our strike price x 100 per option contract.
Going back to the $GME example, let’s say we shorted a single $25 strike put option. The most we could possibly lose ($GME goes to $0) would be $25 * 100 = $2,500.
If we end up accidentally writing an option and want to get out of the contractual obligation, we can buy a matching option to close out of the position. For example, if we sold a call option on $F for a $9 strike with a maturity on 1/1/2021, we can buy the same call option from another writer ($9 strike, 1/1/2021 maturity) to close out our position. Experienced investors short put and call options as a way to generate income, or use the short positions within even more complex strategies. Starting out as beginners, we should avoid shorting or writing options.