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How to Be on the Winning Side of Stock Options

This article is based on my experience from over 45 years of perfecting my stock-trading strategies and risk-control skills.

You can control what happens when you sell stock options short for profit.

You can control what happens when you sell stock options short for profit.

What It Means to Be on the Winning Side

Stock options usually lose value as they approach expiration unless the underlying stock moves quickly in the direction the option buyer hoped would happen. Therefore, it's in your favor when you are the option seller. It works like this:

  1. When one buys an option, they are placing a bet that the underlying stock will exceed a specific price by a certain date.
  2. The buyer pays a time premium that's added to the option. As it gets closer to the expiration date, the time premium decays, and the option loses value.1
  3. If the stock fails to reach the expected price by the expiration date, the option expires worthless.

However, someone sold them that option. It could have been you. Since options tend to lose value, you could be on the winning side! It's best to be the option seller, or option writer, as it's called.

I’ll give you a well-rounded review of the entire process.

How to Be an Option Writer

Instead of buying options, you sell them. You become the option writer, and the decaying time premium works in your favor. Any stock options broker will allow you to do this.

"Writing an option" is the term used for selling an option you don't own. It's also known as selling short.2

How do you write an option? You sell it in your brokerage account just like you buy and sell stocks. When you write an option, you indicate an order to “sell to open.” That is because you are opening the transaction.

It's merely making the trade backward—selling first and buying back later, hopefully at a lower price.

Taking Your Profits

Eventually, you will have to repurchase the option 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 the option's strike price (known as in-the-money), then the option expires worthless. In that case, you don't need to repurchase it. Instead, you just let it expire and keep all the money you got for it.

I don't recommend waiting to let it expire, however. I'll explain why with these two points:

  1. Since options tend to lose value over time, you could have the opportunity to repurchase them for less than you sold them at any time. The difference is your profit.
  2. If the option drops to half the price you sold it for, you should close the trade and take your profit. After all, you already have a 50% profit. It's best not to wait for an entire run, especially if there is still a lot of time left till expiration, because the market can turn against you.

I'll discuss further why it's crucial to close an options trade early after giving you a clear understanding of the initial process.

A Clear Explanation of Selling Options Short for Profit

There are two kinds of options. A "put" and a "call." With this strategy, you will sell, not buy, these options. Again, you are writing the option.3

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The following is what selling a put or a call means:

  • When you sell a put option, you are giving the buyer the right to sell their stock to you at a specific price before the expiration date.
  • When you sell a call option, you give the buyer the right to buy the underlying stock from you at a specific price before the expiration date.

Options have expiration dates from one day to several years. I like to write 30-day options. The time premium decays quickly in the last 30 days, and that works in your favor when you sell short.

You receive a credit to your account for the amount the buyer paid for the option you sold it. And when you close the trade by buying it back, the difference (due to the decay) is your profit.

There are three ways to trade with these strategies:

  1. Sell a call option for a stock you already own. It could get called from you.
  2. Sell a put option when you would like to own the stock anyway. It could get put to you.
  3. Sell either option and buy a cheaper one to limit your risk.

Don't worry if all that is unclear at the moment. I realize there is a lot to absorb, and I'll explain all three of these techniques in detail in the following sections.

Short selling for a credit can be done with puts or calls.

Short selling for a credit can be done with puts or calls.

Pros and Cons of Shorting Call Options

Selling Covered Calls When You Already Own the Stock

If you already own a particular stock and 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 a 30-day call option on that stock. That is known as a covered call.4

You receive a credit to your account from the premium paid by the buyer. You are selling the right to “call” the stock away from you at the agreed price. That is why it’s referred to as a call option.

If the stock price 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 I own!"

The advantage is that you still have the shares and the extra money from the expired call option to make up for the lower price of the stock.

What Can Go Wrong When 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.

However, in that case, your shares will be called away from you. That is because the option buyer exercises their right to buy your shares at the agreed price even though they may be worth more than that now.

Remember that you only do this with a stock you think will not move much in 30 days. And if it does, you'll receive more for it than it was worth when you entered the trade because you'd be selling it at the option's strike price. In addition, you also keep the option's premium the buyer paid.

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 at the agreed option strike price. So you lost out on getting that tremendous gain, but you still 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 big move in that short time. But it can happen.

Pros and Cons of Shorting Put Options

Selling a Put When You Wouldn't Mind Owning the Stock

What if you'd like to buy a stock but are unsure if you should wait for a better price? That might never happen.

In that case, you could sell a 30-day put option. That means you are selling someone the right to sell you their shares at an agreed price—the option's strike price.

Two things can happen:

  1. If the stock price goes below the strike price within 30 days, the option buyer can “put” their shares of the stock to you, and you, in effect, are buying it at the agreed price. That's why it's called a put option.
  2. If the stock goes up in those 30 days, the option buyer can sell their stock on the open market for more. So they would never exercise their option. They would just let it expire, and you keep all of the premium they paid you.

But remember, if the stock falls as in the first scenario, the option buyer will most certainly exercise their right to sell their shares of the underlying stock to you. You would have to buy the stock at a price agreed to by the option's strike price. You were not protected against that outcome. We call that a "naked put" for that reason.5

What Can Go Wrong When Selling Naked Put Options?

Remember that you would be doing this only because you would like to buy the stock anyway. You never want to sell a put option if you are not willing or able to buy the stock.

You will need to have enough money in your brokerage account to buy the shares in case the buyer of the option "puts" the shares to you.

If the stock price goes down, the option buyer will sell you their stock at the agreed strike price. Of course, that is higher than it's selling for on the market, and you have to buy it anyway. But you would also 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 bad because even if this is the case, you are buying the stock at a price that is lower 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 sell you the stock at a lower price than its current market price. 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 anyway, plus you got to keep the premium you received for the option. In effect, you paid that much less for the stock. So it wasn't really a bad thing since you intended to buy the stock anyway.

What's the Worst Case?

Nevertheless, 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 if you wanted to buy the stock anyway. So you're still better off than if you just purchased the shares originally. That's because you also have the profit for the sale of the option—keeping all the premium received.

Alternatively, if you see an options trade going against you and change your mind about buying the stock, you can close the trade early by buying back the option.

Since options tend to lose value as they approach expiration, you could likely buy 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.

Options premium values tend to decay over time.

Options premium values tend to decay over time.

Defining Your Risk 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 you have the funds available to buy the stock if a put option goes against you.

If you only want to work with options and not consider having shares of stock called from you or put to you, you'll need to have a strategy to protect from a worst-case scenario.

You can do that by buying a low-cost option to limit your risk of the short sale with the higher-priced option. We call that a vertical trade.

Using Vertical Trades to Limit Your Risk for Protection

To limit your risk, you buy (long) a further out-of-the-money option at the same time as when you sell (short) for the premium in another option.

Say, for example, you sell a call option to sell XYZ at $50. You can purchase a call option to buy the same stock at $60. That is called a vertical trade. Traders use the term "defining your risk."

You will pay less for the $60 call than you got for the $50 call, so you'll have a credit on the trade. This method locks you into a max risk of the difference between the two strike prices.

You still have to sell the underlying stock at $50 if it goes over that price, but no matter how high it goes, you can always exercise your right to buy the same shares at $60. So $10 is your total risk if this trade goes against you.

Why It's Crucial to Close an Options Trade Early

Markets can change quickly, and a profitable position can suddenly turn against you. You never know when some unexpected world event can occur that turns a winner into a loser.

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 even if the underlying stock doesn't move much.

Of course, the decaying premium may leave you a bigger profit later in the period before expiration. But why chance it? Prices fluctuate, and it's best not to be greedy—hoping the options will expire worthless. Instead, when you have reached 50% profit, take it.

Another reason for taking that 50% profit when you have it is that you can only achieve another 50% gain. But when you close that trade, you can open a new trade with a chance for a more considerable profit and with no additional risk.

Sure, you could just enter an additional trade, but then you'd be doubling your risk. So even though you would be using vertical trades to limit your risk, you wouldn't want to extend that beyond your means. So take your profits on trades that achieve 50% gain and start a new one for greater credit.

How to Close an Options Position Before Expiration

It's easy to close a vertical option position, where you had protected yourself with a spread by short selling a high-premium option and buying (long) an option at a lower cost. You can close that position by simply buying the short option and selling the long option.

Key Takeaway

Options trading can be tricky even for the most experienced professionals. But with the risk control strategies I discussed, and with trading only as an options writer and not a buyer, you can have the odds in your favor. This process can create a consistent revenue stream for you when done correctly.

References

  1. Peter Stolcers. (January 2, 2009). Time Premium Decay. OneOption.com
  2. Tim Smith. (July 9, 2021). What Is Writing an Option? Investopedia
  3. How to sell calls and puts. (June 20, 2018). Fidelity
  4. Alan Farley. (January 14, 2022). The Basics of Covered Calls. Investopedia
  5. Gordon Scott. (August 23, 2021). Naked Put. Investopedia


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

Comments

Glenn Stok (author) from Long Island, NY on January 01, 2016:

Vortrek Grafix - You can find a lot of useful videos from TastyTrade on YouTube as well as on their site. They teach how to sell options in a manner where you define your risk so you put the odds of success in your favor. TastyTrade explained this very well. I talk about them and using the Think-or-Swim platform in my other article - Effective Stock Option Trading with Think-or-Swim.

Vortrek Grafix on January 01, 2016:

Hi Glenn, appreciate the options trading info. Looks like selling options rather than buying options, is a solid percentage play. I like to see live demos in motion so I get more confident with this subject. Hopefully youtube.com will have something on selling options. Thanks for narrowing the focus of what matters from the whole body of this subject way down Glenn.

Glenn Stok (author) from Long Island, NY on August 11, 2015:

Old Poolman - You picked up on another thing I remember learning from Tasty Trade. That is that investing in stocks ties up all your investment. It's all at risk. With these new methods we can define our risk with the spreads. Try asking any professional trader how they define their risk. See if they even understand the question.

What you learned about options trading before learning Tasty Trade you can throw out. I used to think I knew options trading. Remember that buying options is usually a losers game. Since they expire worthless, most people can lose all their money. That's why we don't buy options. We sell them. We sell premium. The premium errodes and we keep the profit. I'm just articulating what you already know for other readers to understand.

Old Poolman on August 11, 2015:

Thanks and I will probably have some questions for you as I get into some new strategies if that would be OK. I just want to make sure I am totally on top of the credit spreads and iron condors I use now before I try to move on.

Your correct that stocks are pretty much the same as flipping a coin, could be heads and could be tails. I guess if one owns a basket full of dividend paying stocks that is how they make their money. But that takes a very large trading budget and ties up a huge sum of money for a long time.

Other option traders I have talked with tell me that through trial and error they have a dozen or so stocks, indexes, and etf's they trade over and over. One gentleman told me these become like old friends and you can fairly well predict what they are going to do at any given time. I hope I can reach that point in my trading career/hobby.

I now know just about enough about options to be dangerous, but I can see the opportunities for anyone with even a small trading account like mine being able to bring in some extra cash or grow that account. Having that extra edge with otions over buying stocks makes a huge difference. I don't even have enough money in my account to buy some of the stocks I trade, but options let me trade them anyhow.

My only regret is not getting into options earlier in life.

Glenn Stok (author) from Long Island, NY on August 11, 2015:

Old Poolman - That's right. You want your options to remain out of the money till expiration. Then you an just let it expire and keep 100% profit. That's why a lower delta is better. Delta of 5 means two standard deviations. There is less premium in it, but a better chance of keeping it all.

Something else I learned from Tasty Trade is that buying and selling in stocks only gives you a 50% chance of success. They can only go up or down. by selling premium and knowing how to place the trade, we increase our chances. But I'm sure you know that part already.

Your comments and my responses to you are not a waste of time. It benefits all who read this. Your comments are very meaningful. No need to worry.

Old Poolman on August 11, 2015:

My problem is remembering I don't really want the trade to end up In The Money, I just want to collect the premium and let the options expire worthless.

One thing I learned the hard way was to remember if I was paper trading or live trading. I accidently bought 100 shares of stock I really didn't want because I thought I was paper trading. So, I sold my first covered call and made a little money. Right after the option expired the stock went up for one day and I sold it for a profit.

I think I have watched every video Tasty Trade has to offer at least once, some twice. The light bulb finally came on, but was still on the dim side. Now it is starting to make sense. I think anyone wanting to get into options trading should start with Tasty Trade and TOS. Besides it costs less per trade if you enter the trade using the Dough Platform.

Ok, I have wasted enough of your time

Glenn Stok (author) from Long Island, NY on August 11, 2015:

Old Poolman - I may write more hubs on the topic if I see more interest. There are presently only about 70,000 people who understand and follow the Tasty Trade methods at this time. Be careful with reading books on trading. After learning from Tasty Trade I see that most "professionals" don't understand that risk can be defined by buying protection with a further out option. I suggest you just watch as many videos from the Tasty Trade archives as you can. They are all there. Professionals also don't realize that buying stocks is more dangerous because all your money is at risk.

Old Poolman on August 11, 2015:

Glenn - I'm trying hard to gain confidence in my trading ability, but some days it just won't work for me.

I wish you didn't live so far away, I would love to buy you a cup of coffee and pick your brain for awhile.

Most of the books I have read actually leave me a little more confused than I was before I read the book. You have a way with words to get the message across and yet keep it simple.

Perhaps you should write a book on options trading?

Glenn Stok (author) from Long Island, NY on August 11, 2015:

Old Poolman - Thank you. I really appreciate the positive feedback comparing my writing to other trading books. That means a lot coming from someone who understands options trading.

Old Poolman on August 11, 2015:

I have read lots of books on trading options, and none of them explained it as clearly and simply as you do. Job well done.

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