Lesson 7: Choosing to be the option seller

We talked about buying calls and puts and discussed some of the strategies that involve being an option buyer in lesson 4. Now let’s think about what it means to be the option seller.

Remember that every option is a contract and every contract has a buyer and a seller. There are times when you might choose to be the option buyer, at other times the option seller. You’ll need to consider which strategy matches your overall trading plan in a particular situation. 

Buying an option contract, also known as buy to open, makes you the owner or holder of the option contract. In return for paying the premium, you have the right to either exercise the contract, let it expire worthless, or sell it back into the market before expiration. Selling to close your position means that you’re selling a contract that you own back into the market. This is different from selling to open, which is described next.

Selling or writing an option contract, also known as sell to open, makes you the seller or writer of the option contract. This can also be referred to as shorting an option. As the option seller, you collect the premium paid by the buyer and assume the obligation to buy (for a put) or sell (for a call) the agreed-upon shares of the underlying stock if the owner of the contract chooses to exercise the option before or at expiry. If the option buyer exercises and requires you to buy or sell the stock, this is known as assignment. Buying to close an options position means that you’re buying back a contract that you sold. Once you’ve done this, your obligation is removed, and you can no longer be assigned on the contract.

You might consider buying an option when you think the price of the underlying asset is about to go up or down substantially or you expect a rise in implied volatility. Many traders buy options because they’re generally cheaper than purchasing shares or require less margin than shorting stock. Options can also be purchased to protect the value of an existing stock holding or short position.

As we mentioned, you can also initiate an option trade by selling an option, also known as sell to open. You might consider selling an option when you think the price of the underlying asset will remain somewhat stable or you expect a drop in implied volatility. Selling options is often used to generate income, to provide some limited protection from an adverse move in an existing position, or to lock in a buy or sell price.

Option sellers can benefit if the underlying stock moves very little, as time value erosion works in their favour. Sellers can also benefit if the stock moves in a direction favourable to them; a large stock move isn’t usually necessary for the option seller’s trade to be profitable when they’re correct. However, there are situations where a trader makes a correct directional prediction and a large stock move does occur. In this case, an option seller will not usually benefit as much as an option buyer who’s also positioned to profit from the same directional stock move. 

There are two additional distinctions within option selling — option sellers can be covered or uncovered.

Covered option selling involves selling options while simultaneously holding a position in the underlying asset. The seller has enough shares of the underlying asset to cover the potential obligation if the option is exercised.

Uncovered option selling refers to selling options without owning a position in the underlying asset. The seller has no or inadequate coverage of the asset to fulfill the potential obligation if the option is exercised.

1. The option buyer’s risk is usually limited to the premium paid, plus commission. Option sellers collect premium when they initiate a trade; however, covered option sellers may face a risk of loss over and above the amount of the premium received. Note that the amount of potential loss can be measured in advance for covered option sellers and adjusted to the investor’s strategy. Uncovered option sellers may be exposed to substantial and possibly unlimited risk. However, hedging positions can reduce this risk for uncovered option sellers.
2. The option buyer generally benefits from a favourable price move in the underlying asset and an increase in implied volatility. Option sellers generally benefit from lower implied volatility after their trade is executed, time value erosion and little movement in the underlying asset. How much the option buyer or seller benefits will depend on a number of factors, but mainly on the degree and timing of the move in the underlying asset, chosen strike price and expiration date. As mentioned previously, option sellers will not usually benefit as much as option buyers from a speculative position when a large move occurs.
3. The option seller benefits and the option buyer is disadvantaged by the passage of time, as there is less time available for the underlying asset to make a substantial move in a particular direction before expiry. From a price standpoint, this is reflected in decay in the time value portion of the option premium.
4. Option buyers may need less margin to undertake their strategy, either in the form of cash or marginable securities. Option sellers may require substantial margin, especially if they are uncovered sellers. In addition, the assignment of a short option might trigger a margin call if there isn’t sufficient account equity to support the stock position.
5. Both option buyers and sellers can exit their trades before expiry, either to realize a profit or to close a position that’s moving against them.

Next up is Lesson 8: Selling uncovered options.