For Option Traders

Selling an option

Lesson in Course: Derivatives and options (beginner, 7min)

I now know what it means to buy and exercise an option. What does it mean to sell options and when should I do it?

Eureka!

What it's about: Different ways we can sell options contracts and the outcomes.

Why it's important: Selling options in the wrong order can result in high risk and assignment.

Key takeaway: Sell-to-close lets us cash out the options we own and reduce our risk. Writing options lets us sell contracts to generate income and increase our risk.

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

There are two different ways to sell an option

Closing an option position

The most common sell order for options is a sell-to-close order

What is Sell-to-close order?

A sell-to-close order is when the holder of an option closes out of their options position by selling the contract. For an order to be sell-to-close, we must have previously purchased the option contract and still own the contract.

Our options are sold at the current market price

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.

Returns from options are generally taxed as income

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. 

Writing an option generates cash right away

As the seller, we:

  1. Select the underlying stock that the contract covers
  2. Pick a maturity date standardized by the exchange that binds the contract
  3. Select the strike price for the contract
  4. Collect the premium from the buyer
  5. Are contractually obligated to the buyer of the option to sell or buy the stock at the strike price

The risks

The risk involving shorting options is that the option ends in-the-money and we are assigned.

Short options expose us to the risk of assignment

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.

GME short call example

We decided to short-sell a single $25 strike call option on $GME on January 1, 2020.

Lesson of the Day: '“Dumb Money” Is on GameStop, and It's Beating Wall  Street at Its Own Game' - The New York Times

Later in the month, the stock price jumped to $347 per share. The holder of the call contract exercises and we are assigned. The holder can buy 100 shares of $GME from us at $25 per share for a total cost of $2,500 while the shares are worth $347 each. We are looking at a loss of $32,200 ( $347 x 100 - $25 x 100). 

 

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.

Actionable ideas

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.

 

Glossary

What is Sell-to-close?

The most common sell order for options is a sell-to-close order where the holder of an option is closing out of their option position by selling the contract. For an order to be sell-to-close, we must have previously purchased the option contract and still own the contract.