Last time we briefly
discussed buying options. Another basic option strategy is selling
options. When buying an option, your loss is limited to the amount
you paid for your option(s), and the potential gain is very large, especially
when compared with the size of the investment. When you sell an option,
your gain is limited to the amount you collected from the sale of the option,
but your possible loss is much greater.
Thus, selling an
option can be a much riskier proposition, when compared with buying an option.
The selling strategy is risky when the position is uncovered, but much
less risky when the position is covered.
A call seller is
covered if
He owns enough stock
so he can deliver (sell) it to the call owner, in the event he is assigned
an exercise notice (notification the call owner has exercised his rights
and demands to buy the underlying stock at the strike price)
A put seller is
covered if
He is short a sufficient
amount of stock so he can buy stock from the put owner, in the event he
is assigned an exercise notice and has to buy the stock at the strike price
So why would anyone
sell an option? There are situations in which selling an option
incurs a limited amount of risk. Those are the situations that I
want to share with you in the coming weeks. We are not going to ever
recommend selling options when the risk is great. Sometimes there
is a large risk that is not apparent, and we will avoid those risks also.
Many brokerage houses
allow you to sell an uncovered put, if you have a sufficient amount of
cash in your account so you can buy stock, in the event you are assigned
an exercise notice on the put you sold. That means you must have
cash equal to the strike price multiplied by the number of puts. For
example, if you sell 3 puts with a strike price of 30, you may be obligated
to purchase 300 shares at 30. The cash requirement is $9000 (plus commissions).
You can use the cash you receive when you sell the puts as part of the
cash requirement.
If a call seller
does not meet the condition of owning enough stock, he is uncovered (or naked).
This is a risky position for the potential loss is unlimited. Some
brokerage houses consider this to be so risky they do not allow you to sell
an uncovered call under any conditions. Others allow a trader to have
uncovered calls, but they require large deposits of margin money to protect
themselves against loss. I recommend you never consider this strategy.
Why is the potential
loss from selling an uncovered call unlimited? If you are short a
call option, and if the stock rises higher than the strike price, you will
eventually be assigned an exercise notice. Since you must deliver
the stock to the person who exercised the call option, you must go to the
marketplace to buy that stock so you can deliver it. In theory there
is no limit to how high the stock can go, so there is no limit to the price
you will have to pay to buy that stock and there is no limit to the amount
you can lose. In practice, there really is such a limit, but since
that limit is unknown, and since it is possible to lose a very substantial
amount of money, selling uncovered calls is the most dangerous of all option
strategies.
Selling a covered
call, however, entails none of the risks of selling an uncovered call,
and is a conservative option strategy. In fact, it is the strategy
I recommend to most public investors. I believe most investors
can make money more often and have safer stock portfolios using this strategy.
The strategy is called covered call writing. Write is the term often
used to describe the selling of a call option when the position is covered.
Next time we’ll
take a closer look at covered call writing.
