How to Trade Stock Options With a Defined Risk Strategy
Stock options lose value over time, which can be used to your advantage by reversing the logic. You can also use options to lock in a maximum risk. I’ll show you how to put the odds in your favor with this strategy.
Let’s begin with an understanding of why options tend to lose value:
- When you buy an option, you are placing a bet that the underlying stock will exceed a specific price by a certain date.
- If it fails to reach that price by the date you specified, it expires worthless.
Options have a time premium added to it when you buy it. As it gets closer to the expiration date, the time premium erodes, and the option loses value.
When you buy stock options, the stock has to move in the right direction and move far enough in time for you to make any money. It's best to be on the side of the option seller, or option writer as it's called.
How to Be a Writer of an Option
Instead of buying options, you sell them. You become the option writer. Any stock/options broker will allow you to do this.
That reverses the logic. Now the eroding time premium works in your favor, as I'll explain.
"Writing an option" is the term used for selling an option you don't own. It's also known as selling short.
How do you write an option? You sell it in your broker account just like you buy or sell stocks. But when you write an option, you indicate an order to “sell to open.” That is because you are opening a transaction.
When I try to explain this to some people, they say they never knew you could sell something you don't own. It's merely making the trade backward, and it's the method that puts the odds in your favor with options.
Eventually, you will have to buy it back to close the trade. That’s done with a “buy to close” order. But you don't always have to repurchase it. If the underlying stock never goes past your strike price (known as in-the-money), then the option expires worthless, and you don't need to repurchase it. You just let it expire and keep all the money you got for it.
I don't recommend waiting to let it expire, especially if you already have a 50% profit, and there is still a lot of time left till expiration. Remember what I said earlier, that most options lose value over time. So you can repurchase it for less than you sold it for, and you keep the difference as your profit.
What Does It Mean When You Sell Options Short?
There are two kinds of options. A PUT and a CALL. With our strategy you will sell, not buy, these options. That's known as selling short. Again, you are writing the option.
- When you sell a CALL, you sell someone the right to buy the underlying stock from you at a specific price before the expiration date.
- When you sell a PUT, you are selling someone the right to sell his or her stock to you at a specific price before the expiration date.
There are three ways to trade these strategies.
- Sell a CALL option when you own the stock, in case it gets called from you.
- Sell a PUT option when you would like to own the stock anyway, in case it gets put to you.
- Sell an option, and buy a cheaper one to define your risk.
With the third technique, you will not get involved with buying or selling the underlying stocks. The process ends sooner than that will occur.
I'll explain all three of these techniques in detail in the following sections.
Options have expiration dates from one day to several years. I like to write 30-day options. The time premium erodes quickly in the last 30 days, and that works in your favor when you sell short.
Method #1: Selling a CALL When You Already Own Shares
If you already own a particular stock and you don’t think it’s going to move much in the next 30 days, you can squeeze some extra money out of it by selling someone else a CALL option on that stock.
You are selling the right to “call” the stock away from you at the agreed price. Now you know why it’s referred to as a CALL option.
If the stock drops or stays the same for 30 days, the option expires worthless, and you keep all the money you got for the option.
You're probably thinking, "But I lost money on the stock!"
You still have the shares, and you also have extra money from the expired call option to make up for the lower price on the stock.
What Can Go Wrong With Selling Covered CALL Options?
When you own the underlying stock for the option you sell, you are covered in case the price goes higher than the option's strike price.
In that case, your shares will be called away from you. That is, the option buyer has the right to buy your shares at the agreed price even though it may be worth more than that now.
Remember that you do this with a stock that you don't think will move much in 30 days. And, by the way, you keep all the premium you received when you sold the option. So even though you lost the stock, you received more than it was worth before entering the trade, and you also kept the option's premium.
What's the worst case?
The terrible thing that can happen is that the stock shoots unusually high, and you are forced to sell it that the agreed option strike price. You lost out on getting that tremendous gain, but you keep the money received for selling the option.
That's another reason for selling options that expire within 30 days. The chances are slimmer for a stock to make a huge move upward in such a short time. But it happens.
Method #2: Seling a PUT When You Would Not Mind Owning the Stock
What if you don’t have shares in a stock and you think you would like to buy it, but you are not sure what it will do.
In that case, you can sell a PUT option. That means that you are selling someone the right to sell you his or her shares at an agreed price. If the stock goes down below the strike price within the 30 days, they can “put” their shares of the stock to you, and you are forced to buy it at the agreed price. That's why it's called a PUT option.
If the stock goes up in those 30 days, they can sell it on the open market for more. They would never exercise their option. They would just let it expire. You get to keep all of the premium they paid you.
What Can Go Wrong With Selling PUT Options?
Remember that you are doing this under the condition that you would like to buy the stock if it goes higher. So it's not a problem if that happens.
You don’t ever want to sell a PUT option if you are not willing, or able, to buy the stock. You need to have enough money in your brokerage account to but the shares in case the buyer of the option "puts" the shares to you.
That means you are covered since you have the money to buy the stock. So you only want to sell "covered" puts. If you're not covered, you are selling naked puts, and that is not advisable unless you lock in a maximum risk value. I'll explain that strategy after we finish discussing this one.
So what if the stock goes down? The buyer of the option will sell you their stock at the agreed price. That strike price is higher than it's selling for on the market, and you have to buy it anyway. But you do keep the premium you received when you sold the option.
That is why I said only to sell PUT options when you want to buy the stock anyway. You may end up buying the stock if you are wrong with the timing or the price.
It's not a bad thing because even if this is the case, you are buying the stock at a lower price than if you had just bought it when you first thought about it.
Why is that? Because the PUT option you sold was an offer to buy the stock at a price that is lower than it was when you sold the option. You agreed to buy the stock at that price in case the stock goes below that strike price by the expiration date.
So you bought the stock at a better price, plus you got to keep the extra premium you received for the option. So in effect, you paid that much less for the stock.
What's the worst case?
If the stock goes extremely low, you are still buying it at that agreed price. That's not such a great deal, because it is worth so much less on the market.
But remember, you did this only in the case when you wanted to buy the stock anyway. So you're still better off than if you purchased the shares originally because you now also have the profit for the sale of the option—keeping all the premium received.
Closing an Option Trade Early
If you see an options trade going against you before the 30 days are up, and change your mind about buying or selling the stock, you can close the deal by buying back the option.
Since options lose value as they approach expiration, you may end up buying back the option at a lower price even if the stock started going against you, as long as it didn't go too far to an extreme.
Method #3: How to Define Your Risk
If you only want to work with options, and not consider having shares of stock called from you or put to you, as in the first two methods, you need to have a strategy to protect from a worst-case scenario.
Options indeed lose their premium value over time, and now you know how to make this work in your favor. But that is only safe if you are covered by having the shares available to sell if a CALL option goes against you, or the money available to buy shares if a PUT option goes against you.
So what to do? You can define your risk. You do that by buying (long) a further out-of-the-money option at the same time when you sell (short) premium in another option.
Say you decide to sell a CALL option to sell XYZ at $50. You can buy a CALL option to buy the same stock at $60. That is called a vertical trade. You will pay less for the $60 call than what you got for the $50 call, so you have a credit on the trade. And what this does is, it locks you into a total risk of the difference between the two strike prices.
No matter how high the underlying stock goes, you can always exercise your right to buy it at $60. You still have to sell it at $50 if it went over that, but $10 is your total risk if this trade goes against you.
How to Terminate a Vertical Position Before Expiration
You don't need to wait for options to expire. Buying and selling the underlying stock is not necessary either. You can simply close the trade by buying back the vertical position, which means buying the short call and selling the long call.
The best strategy is to manage your trades by closing positions when you have a 50% profit. Since options lose value as they approach expiration, gaining such a profit can be expected if the underlying stock does not move much.
So take your profits on vertical trades as soon as you have them. You never know when some unexpected world event can occur that turns a winner into a loser.
Prices fluctuate, and it's best not to be greedy, hoping for the options to expire worthless. Besides, when you close early, you free up the opportunity to enter another trade where you get a higher premium.
As you can see, you can have the odds in your favor by selling options rather than buying them. It's just important to understand the entire process and know how to manage your trades. Hopefully, I have given you some clues on how to do this.
This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.
© 2012 Glenn Stok