Options Buying and Selling
Before explaining complex strategies, I need to explain call options and put options and differences between buying and selling.
(I'm adding down calls chart)
The term "the option is worthless" meaning that the stock price didn’t finish above the strike price in calls or finish below in-puts.
Buy Calls – Bullish “strategy”, you need to select a stock that will go up in price in a reasonable time. Limited loss (The maximum loss is what you paid for the option), theoretically unlimited profit.
Buy Puts – Berish “strategy”, you need to select a stock that will go down in price in a reasonable time. Limited loss, theoretically unlimited profit.
Selling Naked means that you only sell the option contract without owning the shares. 1 option contract equals 100 shares.
Sell Calls (Naked) – In general, this a Berish “strategy”, but it depends.
The seller wants the option to expire worthless, meaning all the value of the option will go to zero, the price of the stock needs to be at the expiration date under the strike price of the option. Theoretically unlimited loss, limited profit.
XYZ worth at the beginning $100 per share.
The seller sold 1 option -
In the money option strike $95 worth - $6 ($5 intrinsic value + $1 time premium)
At the money option strike $100 worth - $3
Out of the money option strike $105 worth - $1
In the money call sold – The seller sold a call at the strike price of $95
If the stock will finish anywhere below 95$ The call seller will profit $600
The stock has to go down at least $5
At the money call sold - The seller sold a call at the strike price of $100
If the stock will finish anywhere below 100$ The call seller will profit $300
The stock can be neutral or go down slightly.
Out of the money call sold - The seller sold a call at the strike price of $105
If the stock will finish anywhere below 105$ The call seller will profit $100
The stock can be neutral or go down slightly or even go up in price and the seller will still profit.
You should notice if the stock will go up in price large loss could happen.
In theory, this loss is unlimited, in practice, the loss is limited by time. The stock cannot rise to infinity.
Naked call selling is not the same as a short sale of stocks. While both have large potential risks, the short sale has a much higher reward potential, but the call selling will do better if the stock remains at the same price.
You can see from the example that the call seller can make money in situations when the short seller would have lost money.
Covered call writing (selling) – I won’t go deep here, this means the seller of the option own 100 shares, the cover call writer is mildly bullish or neutral. People do this to decrease the risk of owning a stock or don’t believe the stock will go very high in price and they want extra profit. This limits the profit potential.
Sell Puts (Naked) – In general, this a Bullish “strategy”, but it depends.
The seller wants the option to expire worthless, meaning all the value of the option will go to zero, the price of the stock needs to be at the expiration date above the strike price of the option. Theoretically unlimited loss, limited profit.
An example of selling puts is exactly the opposite of selling calls. The seller wants the stock price to be above the strike price of the option he sold. (Will show you down with another chart)
What happens in the buyer and seller portfolio after expiration, several cases
We will examine calls buy and sell if the stock finishes above the strike price of the option, for example, the strike price is 100 the stock finish at 105.
The buyer needs to buy from the seller 100 shares ( 1 option contract) at the strike price, meaning he will need to have $10,000, but the stock is at 105.
The buyer portfolio will be with 100 shares long at $100 with an unrealized profit of $500 minus the premium paid for the option minus commissions.
The seller needs to provide those stocks, so he will be short 100 shares at $100, with a loss of (-$500) plus the premium he received from the buyer for the option, minus commissions.
If the stock finish below the strike of the call option, the option is worthless and the buyer lost the debit he paid for the option, the seller received all the credit.
No stock transaction is happening.
Time – The more we get closer to expiration the greater the time decay, this is good for the seller and bad for the buyer, remember the seller wants the option price to go to zero, receive all the credit.
Volatility – Raise in volatility is good for the buyer and bad for the seller, when volatility raises the option gets more expensive. If the option that was bought now worth more because of the rise in volatility the buyer profit from it.
There is a lot more to say about this subject, every strategy has a different consideration that needs to be taken into account.
Note: Naked option selling is usually a strategy for professional traders.
Buy put – option price -> 129.4 , stock price -> 3286.33 , strike -> 3045, days -> 52 , implied volatility -> 47.4% (0.474), date-> 27/10/2020
Sell put – option price -> 127.25 , stock price -> 3286.33 , strike -> 3045, days -> 52 , implied volatility -> 47.4% (0.474), date-> 27/10/2020
Call options BUY or SELL