Options selling is a strategy in finance that involves an investor or trader creating and selling options contracts.
Options selling are also referred to as writing options. Using options, you can manage risks, enhance your gains, and master the art of financial trading. So, what exactly is an option selling? Option selling meaning refers to a derivative agreement between two parties to sell an underlying asset at a defined price at some later date.
However, there is one interesting aspect of options: The option selling strategy does not obligate the buyer to fulfil the contract. In this article, we will go into more detail about option selling.
What Is Options Selling?
Option Selling is a contract between two parties who agree to buy or sell an asset at a predetermined price at a specific date in the future. When selling options, the buyer is not obligated to fulfil the contract. But, the seller must adhere to the contract. So, to offset this risk, the seller receives a premium on the Selling Options contract.
Option sellers benefit from higher premiums. After the option seller has initiated the trade and received the premium, they usually want options to expire worthless to pocket the premium.
Types Of Options Selling
There are two types of options selling–put options and call options. Let’s explore them in detail:
Put Options
Traders sell put options when they expect the market to perform well and their stocks to rise. The reward for buyers of put options is the exact opposite for sellers. The sellers expect the stock price to remain unchanged or climb above the strike price.
One of the attractions of selling puts is that a trader can earn cash upfront and may never have to purchase the stock at the strike price. When the option expires, traders will earn a profit if the stock price is higher than the strike price.
Call Options
By selling a call option, one purchases underlying securities at a predetermined price before a specific date. The seller receives a premium in exchange for their agreement. If the buyer requests, it transfers the stock for a specific price before a specified date.
A premium is considered a seller's profit, regardless of whether the price increases, remains the same, or decreases. If the rate rises, the seller could lose the entirety of the premium, if not even more.
Remember that profit can only be as high as the money received by selling the call option. However, the bad side is the potential loss can be limitless. That’s why there are several selling call options strategies. Such as covered calls, naked calls, and sell-to-close strategies.
Benefits of Options Selling
The benefit of options is that they reduce the cost of holding stock. For example, if you have held a stock for a long time and the price has remained the same. Then, you can sell higher call options, earning a premium and reducing your holding costs.
An important benefit of option selling is the ability to generate income. You receive a premium from the buyer when you sell an option. You keep this premium regardless of whether the option is exercised or expires worthless. This income can be used by option sellers to enhance their overall returns
Things To Consider While Selling Options
You should always keep the following points in mind while selling options. Remember that the Options Selling Strategy has unlimited potential for loss, while profits are finite. Other points include:
In Options Selling, if the seller believes that the stock will not go below a particular level, they will sell a put option (which entitles the holder to sell it). Accordingly, if the writer believes the index or stock won't rise above a certain level, he will sell a call option (which gives the holder the right to buy the stock).
The seller of a call option or put option has unlimited risks. For instance, if you sell a Tata Motors 400 call option for Rs. 10, then your maximum profit is Rs. 10. But if and when the stock price rises to, say, Rs. 450, then the loss will be Rs. 40 [(450-400) - Rs. 10 premium].
Option sellers should trade with strict stop losses. Whether you've sold a put option or a call option, keeping stop losses in place is always a good idea. To protect your capital, stop losses can be set according to the stock's market price or its option price/rate.
Additionally, the seller of the Option is responsible for paying the margins called MTM and any extraordinary volatility margins according to the market conditions. Therefore, when you sell options, these costs must be considered.
Another important point is that the selling options strategy works best when there is a clear-cut trend in the stock market.
There is a trade-off between in-the-money options and out-of-the-money options for each option seller. An ITM option, or in-the-money option, gives you a higher premium, but it also comes with a greater risk. In contrast, the OTM, or out-of-the-money option, comes with lower risk and premium potential.
Time value plays a key role in option selling. When a seller sells an option, the premium exhausts over time. In this way, the seller can exit at a profit. Wondering how? It can be done by buying back at a lower price or level. As a result, an option seller must value time. In contrast to option buyers, whose relationship with time is usually against them, option sellers have an advantageous relationship with time.
Conclusion
Option selling involves selling an underlying asset at a defined price at a future date. An interesting aspect of options selling is that the buyer is not obligated to fulfil the contract. Additionally, there are two types of option selling: call and put. The call option gives the right to buy an asset, while the put option gives the holder the right to sell an asset at a specific price and time. Furthermore, there are several benefits of option selling, such as hedging cost efficiency. However, before you start option selling, ensure to read the points mentioned in the article.
