Position Characteristics #3 Selling Premium

An examination of selling call and put spreads.

The last 2 articles examined the characteristics of buying stock or calls for an upwards move, and selling short stock or buying puts for a downwards move. The one thing in common is that for those positions the price MUST make the expected move to generate a profit for those positions.

There are times though when the price just seems to be stuck in the mud and is not making a good up or down move. There are other times when the price has already made a large move and is showing indications that a top or bottom is forming. These are prime occasions where you can sell options.

The basics

The writer (seller) of a call is agreeing to sell the stock for the agreed upon (strike) price for a specified period of time. The writer (seller) of a put is agreeing to buy the stock for the agreed upon strike price for a specified period of time.

When you sell an OTM (Out of The Money) option you are primarily selling TIME. There is no real value to an option that is OTM, the value that it holds is in the potential that the price has to move In The Money within the allotted time of the contract. This is how you make the profit on selling options, you let it just sit in the mud, or form that top/bottom that it is forming and just eat away at that time value. As the time decreases, and while the price remains OTM, the value of that option also decreases. And when you sell an option, you would like to see the value of it drop to 0 so you can keep all of the premium that you sold.

How it works

If our favorite hypothetical stock XYZ is trading at $47, and there is 4 weeks to go before the next options expiration, the $50 calls could sell for around $2.00. So if you were to sell 1 contract of the 50 XYZ calls for $2.00 you are agreeing to sell 100 shares of that stock at $50 per share at any time during the next 4 weeks. What happens if XYZ remains below $50 for the 4 weeks? On expiration day that contract will be WORTHLESS! Why would anyone want to pay you $50 per share when they can buy it cheaper on the open market? That is right, they wouldn’t, so that contract expires, and just goes away. And that $2.00 (total of $200 because one contract represent 100 shares) is yours to keep. The trade is over and you have made a profit.

With XZY trading at $47, with the same 4 weeks to go until the next expiration, the $45 puts could be sold for $2.50. So if you sell 1 contract of the 45 XYZ puts you would collect $250.00, and you are agreeing to buy 100 shares of XYZ stock at $45 per share for the next 4 weeks. What happens if the price of XYZ remains above $45? The person that wants to sell XYZ will not want to sell it to you for $45, he will want to sell it on the open market for more than $45, so the contract will not be exercised, and it will expire worthless, meaning you keep the $250 that you collected when you sold the puts.

The catch

In the above examples the price remained below $50 for the calls that we sold, and it also remained above $45 for the puts that were sold, so that each one would expire worthless, resulting in a nice profit on the trade. That is just what you want to see happen when you sell that premium. But, that is not how it will go each and every time. What happens to the calls if XYZ announces tonight that they found the cure for cancer? Tomorrow that stock will open for $100 per share. The person that bought the call you sold comes to you and exercises that contract, meaning you have to sell him the stock at $50. If you already owned the stock, then you sold a covered call, and you can deliver the stock to the buyer. But if you do not already own the stock, then you have to buy 100 shares of stock on the market. This will cost you $10,000 to buy the 100 shares at $100 each. Then you can honor the contract and sell the stock for $50 per share, resulting in a $5,000 LOSS!

Or tonight XYZ could announce that they have been cooking the books, and tomorrow the stock opens at $5. The person that bought the 45 put from you will be knocking on the door asking you to honor your contract and buy that stock from him for $45 per share. You are now the proud owner of 100 shares of XYZ stock that you just paid $4,500 for, but it only worth a measly $500. So overnight you just suffered a $4,000 LOSS!

Basically when you sell an option, you have a defined reward, and an UNLIMITED risk. Ok, when you sell a put, the risk is also defined, the stock price can not go below 0, but this still leaves you with so much risk, that you take the chance of losing your entire account and could wind up owing your broker from just one bad trade. It would depend on just how many contracts you sold, and how bad the price went against you. The example above involves selling a naked option, one that is not covered to give you some protection. This is very easily remedied. Instead of selling a naked option, you sell a spread.

Spreads

There is nothing complicated to a spread. We will begin with a call spread. XYZ is trading at $47 and the 50 call can be sold for $2.00. The way that we protect this position is to buy the 55 call, which can be bought for 30¢. This does 2 things. The first it reduces the amount that you collect. You now get $1.70 for selling the XYZ 50/55 call spread, so your reward is reduced. The second thing it does it that it defines your maximum loss at $5.00 minus the premium collected of $1.70, for a total maximum loss of $3.30. If XYZ cures cancer and the price skyrockets to $100 overnight, you will still have to honor the contract on the call you sold, and you will have to sell the stock at $50. But instead of buying the stock on the open market at $100, you will exercise the call that you bought, and you will make some other poor sap sell you 100 shares of XYZ at $55. Thus your maximum loss is $500 minus the $170 you received when you sold the premium for a total loss of $330 for selling 1 call spread.

And we do the same thing with the puts. You sell the XYZ 45 put for $2.50 and you buy the XYZ 40 put for 50¢. You collect $2.00 in time value premium, and if the worst case situation happens, your maximum loss is only $500 minus the $200 premium collected for a total loss of $300 not $4,500.

I want to interject one thing at this time. I do NOT believe in selling a naked option, any time I talk about selling time, selling premium, or selling calls or puts, I AM referring to selling a spread!

The defined risk is the difference in the 2 strike prices, and the profit is defined by the amount collected when the spread is sold. Normally a spread is sold that has 4 or more weeks until it expires, which does lend itself to using the longer term weekly and monthly charts to gain a good perspective on the position.

Lottery ticket

In the previous article on buying calls and puts, I made a reference that buying an OTM option that has very little time left has about the same odds as buying a lottery ticket. If a lottery ticket is so bad for the buyer, then that tells us that it favors the seller. This is a shorter term trade, one that would be entered with 2 weeks or less until expiration, and the further OTM the option is the better. There is one thing about selling lottery tickets though. The reward is small, you may only collect 50¢ and still have that $5 difference between the strikes on the spread. So while many lottery tickets do expire worthless, it would not take very many that wind up In The Money to do some damage to your account balance.

The biggest advantage to selling a spread is that you are taking advantage of the natural tendency of the price to stagnate. When the price is forming a top, and you sell a call spread, you are in essence saying that the price will NOT go up past the strike price that you sold. You don’t care if it moves sideways, and you don’t care if it moves down. So instead of being in a position where the price must be moving down, you just care that it does not move up. The same applies when you sell a put spread, you are saying that the price will NOT go down past the strike price you sold. You don’t care if it moves sideways or up. This allows you to enter a position where you just sit back and let time work for you. You will want to periodically check on the position to make sure the price has not moved thru the strike price that you sold. This can take all of 5 minutes a day. While the price remains OTM, you leave the position alone and let the time value drain away.

Selling options work best when the price is not in a trend. They are great for when a trend is ending, and for when the price is moving sideways. The most premium will be received when you have plenty of time before the option expires, and the nearer the stock price is to the strike that is sold. When the price is in a trend, you are taking a higher risk that it will move past the strike that you sell.

With this strategy you do NOT want to sell a strike that is ITM (In The Money). Because when you do that, instead of having 2 ways for the price to move and give you a profitable position, you have reduced yourself to a directional position where the price MUST move in your favor to get OTM and allow you to keep the premium sold. And with the limited reward that comes with selling premium, if you want to sell an ITM option, you are better off to just buy a call or put to take advantage of the move in the selected direction.

We have now covered the basics of positions that take advantage of when the price is moving up or down, and also when it is not moving. Now that we know what the characteristics are of these positions, in the next article we are going to start to look at some charts to show situations that will let us know which position is showing the best prospects of making a profit.