Great Stuff Special Edition: The Dark Side of Options Trading
Welcome to day 2 of Great Stuff’s primer on options trading!
If you tuned in yesterday, you know that we’re forgoing our usual mission to suck the marrow out of the financial media’s headlines. Instead, it’s time to teach you about options trading!
(It’s also because I’m attending a company retreat in sunny Orlando, Florida, this week.)
Wait, you aren’t just joining us on day 2 of this course, are you?
Slow down there, buddy. I strongly suggest you retrace your steps and check out the basics on day 1 before you go any further.
Did you read day 1 yet? No? Well, it’s your funeral.
Yesterday, we covered buying calls and puts. Today, we’re getting into the dark side of options trading: selling calls and puts.
Like I said yesterday, there are two sides to every option contract: one that writes (or sells) the contract and one that buys the contract. When you buy a put or call option, you’re (obviously) the buyer.
But who’s selling? That’s typically a market maker — i.e., a member of the exchange who’s authorized to buy and sell securities such as options.
That may oversimplify the market makers’ jobs, but just know they can also buy options contracts. That means that you can sell both call and put option contracts … that is, once you request access to trade options from your brokerage.
Yes, it’s just like a kindergarten field trip: Your brokerage will have you fill out a personal information sheet before you can buy or sell options. This varies from broker to broker, and your best bet is getting on the phone with them or visiting your brokerage’s website.
So, get your permission slip signed! Before you start trading, you have to prove that you’re qualified.
What do I mean by that? Remember that put and call option contracts represent 100 shares of a stock, right? Well, in order to sell something, you have to prove you can deliver it. It’s just common sense.
But Mr. Great Stuff, why would I want to sell options in the first place?
Why do we do anything in the stock market? To make money!
Just like we showed you how to make money buying calls and puts, we’ll break down examples of how to sell calls and puts.
Warning: Selling options is not for everyone. If you’re interested in these strategies, consult your broker or a qualified financial adviser. Never trade options with money you aren’t willing to lose.
Popping Income With Options: Selling Covered Calls
Let’s look at an example of selling calls. Say you own at least 100 shares of Tesla Inc. (Nasdaq: TSLA). Holding the shares just doesn’t cut it for you anymore, so you decide to make money by selling call options.
By selling a call option contract, you’re willing to deliver 100 shares of TSLA for the agreed-upon price (or strike) within the specified time. (Confused? Go back and read day 1!)
By owning at least 100 TSLA shares, you’re qualified to sell this contract. Think of the TSLA stock you have in your account as collateral to cover the sold call option.
Unsurprisingly, this strategy is known as a covered call position. Since you have the 100 shares on hand, you sell one TSLA May $700 strike call and collect $90 per option, or $9,000 for the entire contract. (Remember: $90 times the 100 shares in the contract = $9,000).
Why would you do this? There are two main scenarios:
- You want to take profits on an existing TSLA stock position and lock in a price while making a little money on the side.
- Tesla isn’t going up at all, and you want to make a little side money.
In both cases, you keep the $9,000 you received for selling the call option contract.
In scenario 1, you also profit from selling 100 shares of TSLA at $700 each, if Tesla shares move above the price (or strike) at which you agreed to sell.
Scenario 2 is a bit different. Here, you expect Tesla’s stock price to stay flat or even fall. Say the shares close below $700 when your sold May call expires. In this case, you keep your 100 TSLA shares and retain the $9,000 you received for selling the call option.
This brings us to a rather important point. By selling a call using stock that you own, you need to know that you can lose that stock if the option contract is exercised — i.e., if the contract’s buyer decides to take advantage of the contract, which they have the right (but not the obligation) to do at any time.
In other words, do not sell calls on any stock you don’t want to lose. If you do … you’ll have a bad time if the call buyer executes the contract and takes your shares.
So, I have to have 100 shares of a stock to sell a call option. What about selling put options? There’s nothing to “own” there.
You, dear reader, are very astute. I was just getting to that…
Options Trading Laid Bare: Selling Naked Calls
You don’t always need to own a stock to sell a call option on it. This is called naked call selling. (Yes, naked … stop snickering.) It’s not a strategy we recommend, but let’s run through it before we get into the greater stuff.
Even if you don’t own a certain stock, you can still sell a call option on it … if you prove that you can uphold your side of the contract. You are, after all, promising to deliver 100 shares of stock to whomever buys your call option.
To do this, you need a margin account with your broker. Margin is essentially cash in your brokerage account set aside to cover purchases and other expenses. It’s not actively being used to invest, so it’s in the margin of your account.
Since margin rules can vary between brokerages, you’ll need to contact your broker for specifics (or to see if you’re even allowed to sell naked options). For an idea of what you’re getting into, here’s a link to the Financial Industry Regulatory Authority guidelines on margin requirements — it’s not for the faint of heart.
Man, that’s intense … is option selling even worth it?
It all depends on your risk tolerance and your investment strategy. Selling options is risky, but it can also be an excellent source of income. It can even let you buy stocks at a discounted price (and get paid to do it!)
Returning to our TSLA example. If you don’t own 100 TSLA shares, but you meet your brokerage firm’s margin requirements, you can sell naked TSLA calls. In the example above, selling a TSLA $700 strike May call nets you $9,000 cash instantly. If Tesla remains below the sold strike when the contract expires, you keep that money.
Sounds simple, right? Well, keep in mind that you have a hoard of cash sitting in your margin account, not doing anything but securing this sold call. If that fits your risk tolerance and investment strategies, then it’s pretty simple.
However, if TSLA rallies above $700 … you’re on the hook for 100 shares at market price. Since there’s no limit to how high Tesla stock can go, you’re open to potentially unlimited risk! You can quickly go from $70,000 for 100 TSLA shares to $1 million or more in a heartbeat.
(Great Stuff Note: We do not recommend naked call selling … just so you know.)
Now for the Good News: Selling Naked Puts
OK, I’ve got the heebie-jeebies now. Wait … what was that part about getting paid to buy stock?
This is the part where selling naked options can be very rewarding.
So, you know that buying a put option contract gives you the right (but not the obligation) to sell a stock at an agreed-upon price (or strike) within a certain period of time.
When you take the other side of that contract — i.e., selling a put option — you agree to buy a stock at an agreed-upon price during that time. But remember: You still need your broker’s permission and enough margin to sell put options.
So, how does this work?
Say you want to buy TSLA, but you don’t want to pay $700 a share. You’d rather get a bargain and pay just $500 per share. Instead of just waiting around for TSLA to fall that far, you sell a $500 strike May put for $90, or $9,000 for the full contract.
Now, all you have to do is sit and wait.
If TSLA falls to $500 or lower, you get to buy the shares for the price you want. You also keep the $9,000 you received for selling the put contract. If Tesla doesn’t drop to $500, you still keep the $9,000 … plus, you can do it again the next month!
In short, you get paid to name the price you want to pay for a stock. This is all within reason, of course. Someone still has to be willing to buy the put contract you sell, and no one would buy a $1 strike TSLA put contract, no matter how badly you want to sell one!
So, let’s recap today’s dark-side data dump:
- Selling options can generate income.
- Selling covered calls is a way to make money on stocks you already own.
- Never sell calls on a stock you want to keep.
- Selling “naked” options requires a margin account and your broker’s approval.
- Great Stuff does not recommend selling naked call options!
- Selling put options is a way to name your price on a stock you want to own and get paid for it.
- Someone still has to want to buy what you’re selling.
And that, dear readers, is day 2 in the bag.
If you’d like to learn more about put selling, Banyan Hill expert Chad Shoop has you covered. Click here to learn all about selling puts in Pure Income.
Now, this was a lot to take in in two days. Luckily, we made you a handy guide to keep close to your heart for whenever the urge to trade arises.
If you have any questions, feel free to send them to us at GreatStuffToday@banyanhill.com, and we’ll see what we can do!
And if you’re still craving more Great Stuff, you can check us out on social media: Facebook and Twitter.
Until next time, good trading!
Regards,
Joseph Hargett
Editor, Great Stuff