Options offer leverage, allowing traders to pay a relatively modest premium to get exposure to 100 shares of the underlying stock per option contract. But as with stocks, just as you can buy options, you can also short them, also known as writing an option, counsels Scott Chan, editor of The Complete Investor.
When you write a call, you are selling to the counter-party the right to buy from you, on or before the option expiration date, 100 shares of the underlying stock per call contract. And when you write a put, you are selling to the counter-party the right to sell to you, on or before the option expiration date, 100 shares of the underlying stock per put contract.
In practice, calls are very rarely exercised early, while puts are more commonly exercised early. To see why, let’s say you own 100 shares of XYZ and you buy a protective put with a strike price of $25. The stock has fallen to $20 but the put option doesn’t expire for another month. If you don’t plan to keep XYZ anyway, it makes sense to exercise the put now and convert your shares into cash.
A dollar today is worth more than a dollar tomorrow. If you are going to put XYZ to the option writer at expiration anyway, it wouldn’t make sense to wait another month. By exercising early, you receive $2,500 now rather than later. You can deploy that cash somewhere else and make money with it.
When you buy an option, the maximum you can lose is the price (the premium) you paid for the option. However, if you are on the short side of the trade, your potential loss is larger. When you write an option, the premium you receive is the maximum gain. If the underlying stock moves strongly against you, you could stand to lose quite a bit.
In the case of a put, as the put writer, your maximum potential loss is the difference between the strike price and zero minus the premium received (then multiplied by 100). So if you sold a $20 put for $1 and the company suddenly declares bankruptcy and the stock falls to essentially zero, the counter-party could put the stock to you at $20. Your loss would be $1,900 — ($20 – $0 – $1) x 100.
As a call writer, your maximum potential loss is the difference between the stock’s price and the strike price minus the premium received (then multiplied by 100). Since there’s no cap to how high a stock can go, theoretically there’s no limit to maximum loss.
Given the limited upside and large potential loss, why then would someone write a call or put? According to the Chicago Board Options Exchange, only about 10% of options are exercised. About one-third expire worthless, and the rest are closed prior to expiration.
Thus, if things aren’t going in your favor, you can always cover your position to cut your losses. So the theoretic maximum loss scenario likely won’t happen. And if the option expires worthless, you can write another one against the same stock to generate income as though you were collecting a dividend.
Moreover, you can write an option in conjunction with other option trades to manage risk and limit the potential downside. Done correctly, it’s possible to generate regular streams of investment income from the premiums.
Of course, the larger the percentage of options that expire worthless, the better your results as an option writer will be. That’s where experience and skill come in.
