Selling options – some examples

Selling options – both calls and puts – may be a little more challenging to understand than buying, but it can be useful for flexibility, and particularly in hedging.

Selling a call, also known as making a short call or written call, can generate a profit when a long call (buying an option) would result in making a making a loss and vice versa.

The reason is that options are a decaying asset. Their value decays with the passage of time and they expire.

This time decay works in your favour if you are an option seller.

That’s because the less time until expiry, the less chance the option has to go in the money. The option price becomes less valuable to the holder each day – benefiting the option seller.

A short call option can therefore create a limited profit in a short time.

The option seller makes a profit as long as the underlying price is below the strike price plus the premium collected. The option buyer can profit only if the underlying price goes above the strike price, plus the premium paid.

Selling a call

This is a strategy that you might use if you were bearish about the prospects of the underlying market – you thought it would fall – or if you thought the price was likely to stay the same.

The profit/loss profile of a sold call is the mirror image of the profile of a long call.

Let’s take another example using the FTSE 100, with a strike price of 6500 and a 35-point premium, and look at the value of the sold call for different levels at expiry:

If the underlying market is above the breakeven point of 6535 at expiry, you’ll lose overall on the trade. If it expires at 6500 or below, you’ll make a profit equal to the premium.

Risk
Selling, or writing, a call option is a risky strategy. Your potential risk is unlimited, as the underlying price could theoretically increase to infinity. If the market rises rapidly, you could suddenly find yourself with a runaway, uncapped loss on your hands.

Reward
The maximum possible profit for writing an option is the premium. In our example, the seller of the call will make 35 points provided the FTSE expires at 6500 or lower. Carefully used, this means that a sell could offer a good prospect for profit.

Selling a put

You would use this strategy if you had a neutral-to-bullish outlook for a particular market – so you thought the price was likely to stay the same or to rise.

The profit/loss profile for selling a put is exactly the opposite of the profile for buying a put. Let’s look at this for a FTSE option with a strike price at 6150 and a 50-point premium.

If the FTSE is at or above 6100 on expiry, you’ll make a profit. If not, you’ll make a loss. Your maximum profit will be achieved if the FTSE is at or above 6150 on expiry.

Risk
Selling a put option involves substantial risk, although your potential loss isn’t completely unlimited, as it is when you sell a call option.

As the market price drops, the value of the put for the holder increases – which isn’t so good for the seller. The worst-case scenario occurs if the underlying asset drops to zero. This would give you a loss equal to the strike price minus the premium.

Reward
The maximum reward is the premium. In our put option example, as long as the FTSE stays at 6150 or higher, as the option seller – or writer – you’ll make all 35 points of premium.