By Hrishikesh Menon. Edited by Arjun Chandrasekar.
There are 2 types of options contracts: calls and puts. Most options traders trade long calls or puts. But where do they buy the calls or puts from? The seller of the option sells the contracts. In this article, we’ll be discussing how sellers sell options.
How Does Selling Options Work?
As stated above, when a trader wants to buy options, someone will have to sell those options to them. These sellers are also called the writers of the option. When buying options, you have the right, not the obligation, to buy/sell the underlying asset at the determined (strike) price. If and when the buyer decides to buy/sell the underlying, the seller will be obligated to buy/sell the underlying to the buyer.
For example, Mark wants to buy a TSLA call with a strike $710, expiry 8/20. John, the seller of the call, will have to sell 100 shares of TSLA at $710 whenever Mark decides to exercise his option.
How Does Selling Options Make Profit?
The buyer of an option must pay a premium. This premium is collected by the seller — therefore becoming the profit. When you buy a call, you are bullish on the underlying and when you buy a put, you are bearish. Similarly, when you sell a call, you are bearish on the underlying and when you sell a put, you are bullish. Since the only profit that you earn from selling an option is the premium you receive, the profit will be limited unlike when you buy a call (since buying puts also limits profit since the underlying can only go down until $0). Selling options can be a great passive income stream as long as the option expires worthless to the buyer.
In an option, there is an intrinsic and extrinsic value. The extrinsic value is the time period of the contract and the intrinsic is the value if the option were exercised today. Since the seller does not exercise the option, only the extrinsic applies to the sell side. When you buy an option, the time value will be in decline until it expires or until you exercise it so when you sell the option, the time value will increase therefore generating more premium income as the days go by.
Let’s take the example above: say John receives $10 in premium since the premium of the call was $0.10/share (a contract has 100 shares so $10). 2 things may happen from now, either the call can go in favor of Mark (passes $710) and he decides to exercise the option at which point John would have to sell him 100 shares of TSLA while keeping his $10 in premium, or the stock may never reach the strike price and expire worthless which will allow John to keep his 100 shares of TSLA and his $10 in premium.
Risks of Selling Options
While selling options is certainly less riskier than buying, there are instances where the seller could lose a lot of money. When selling a call, you are bearish on the underlying but the price can go up infinitely. While this is definitely a worst-case scenario, the losses will be huge for the seller if the buyer decides to exercise the option at a much higher price. Similarly, selling puts are also risky if the price drops far more than anticipated. At least in this case, the risk is limited since the price can only drop to $0, but that is still a lot of financial damage.
To hedge against such scenarios, sellers use multi-legged options strategies, with covered calls/puts being the most common. A covered call is when you own 100 shares of the underlying and sell a call on the same underlying so that if the buyer makes a profit and decides to exercise the option, the seller can offset the losses by selling the buyer the 100 shares which the seller already owns. A covered put is the opposite of a covered call. It’s when you short 100 shares of the underlying and sell a put.
In short, the seller of options has the obligation to sell/buy the option if the buyer decides to exercise the option. When you sell a call, you are bearish on the underlying and when you sell a put, you are bullish. The profit made from selling options comes from the premium received. And to hedge against losses on selling options, sellers usually use multi-legged option strategies such as covered calls/puts.