The Ins and Outs of Selling Options

In the world of buying and selling stock options, choices are made in regards to which strategy is best when considering a trade. Investors who are bullish can buy a call or sell a put, whereas if they're bearish, they can buy a put or sell a call.

There are many reasons to choose each of the various strategies, but it is often said that "options are made to be sold." This article will explain why options tend to favor the options seller, how to get a sense of the probability of success in selling an option, and the risks associated with selling options.

Intrinsic Value, Time Value, and Time Decay

For review, a call option gives the buyer of the option the right, but not the obligation, to buy the underlying stock at the option contract's strike price. The strike price is merely the price at which the option contract converts to shares of the security. A put option gives the buyer of the option the right, but not the obligation, to sell the stock at the option's strike price. Every option has an expiration date or expiry.

There are multiple factors that go into or comprise an option contract's value and whether that contract will be profitable by the time it expires. The current price of the underlying stock as it compares to the options strike price as well as the time remaining until expiration play critical roles in determining an option's value.

Intrinsic Value

An option's value is made up of intrinsic and time value. Intrinsic value is the difference between the strike price and the stock's price in the market. The intrinsic value relies on the stock's movement and acts almost like home equity.

If an option is extremely profitable, it's deeper in-the-money (ITM), meaning it has more intrinsic value. As the option moves out-of-the-money (OTM), it has less intrinsic value. Options contracts that are out-of-the-money tend to have lower premiums.

An option premium is the upfront fee that is charged to a buyer of an option. An option that has intrinsic value will have a higher premium than an option with no intrinsic value.

Time Value

An option with more time remaining until expiration tends to have a higher premium associated with it versus an option that is near its expiry. Options with more time remaining until expiration tend to have more value because there's a higher probability that there could be intrinsic value by expiry. This monetary value embedded in the premium for the time remaining on an options contract is called time value.

In other words, the premium of an option is primarily comprised of intrinsic value and the time value associated with the option. This is why time value is also called extrinsic value.

Time Decay

Over time and as the option approaches its expiration, the time value decreases since there's less time for an option buyer to earn a profit. An investor would not pay a high premium for an option that's about to expire since there would be little chance of the option being in-the-money or having intrinsic value.

The process of an option's premium declining in value as the option expiry approaches is called time decay. Time decay is merely the rate of decline in the value of an option's premium due to the passage of time. Time decay accelerates as the time to expiration draws near.

Higher premiums benefit option sellers. However, once the option seller has initiated the trade and has been paid the premium, they typically want the option to expire worthless so that they can pocket the premium.

In other words, the option seller doesn't usually want the option to be exercised or redeemed. Instead, they simply want the income from the option without having the obligation of selling or buying shares of the underlying security.

How Option Sellers Benefit

As a result, time decay or the rate at which the option eventually becomes worthless works to the advantage of the option seller. Option sellers look to measure the rate of decline in the time value of an option due to the passage of time–or time decay. This measure is called theta, whereby it's typically expressed as a negative number and is essentially the amount by which an option's value decreases every day.

Selling options is a positive theta trade, meaning the position will earn more money as time decay accelerates.

During an option transaction, the buyer expects the stock to move in one direction and hopes to profit from it. However, this person pays both intrinsic and extrinsic value (time value) and must make up the extrinsic value to profit from the trade. Because theta is negative, the option buyer can lose money if the stock stays still or, perhaps even more frustratingly, if the stock moves slowly in the correct direction, but the move is offset by time decay.

However, time decay works well in favor of the option seller because not only will it decay a little each business day; it also works weekends and holidays. It's a slow-moving moneymaker for patient sellers.

Remember, the option seller has already been paid the premium on day one of initiating the trade. As a result, option sellers are the beneficiaries of a decline in an option contract's value. As the option's premium declines, the seller of the option can close out their position with an offsetting trade by buying back the option at a much cheaper premium.

Volatility Risks and Rewards

Option sellers want the stock price to remain in a fairly tight trading range, or they want it to move in their favor. As a result, understanding the expected volatility or the rate of price fluctuations in the stock is important to an option seller. The overall market's expectation of volatility is captured in a metric called implied volatility.

Monitoring changes in implied volatility is also vital to an option seller's success. Implied volatility is essentially a forecast of the potential movement in a stock's price. If a stock has a high implied volatility, the premium or cost of the option will be higher.

Implied Volatility

Implied volatility, also known as vega, moves up and down depending on the supply and demand for options contracts. An influx of option buying will inflate the contract premium to entice option sellers to take the opposite side of each trade. Vega is part of the extrinsic value and can inflate or deflate the premium quickly.

An option seller may be short on a contract and then experience a rise in demand for contracts, which, in turn, inflates the price of the premium and may cause a loss, even if the stock hasn't moved. Figure 1 is an example of an implied volatility graph and shows how it can inflate and deflate at various times.

In most cases, on a single stock, the inflation will occur in anticipation of an earnings announcement. Monitoring implied volatility provides an option seller with an edge by selling when it's high because it will likely revert to the mean.

At the same time, time decay will work in favor of the seller too. It's important to remember the closer the strike price is to the stock price, the more sensitive the option will be to changes in implied volatility. Therefore, the further out of the money or the deeper in the money a contract is, the less sensitive it will be to implied volatility changes.

Probability of Success

Option buyers use a contract's delta to determine how much the option contract will increase in value if the underlying stock moves in favor of the contract. Delta measures the rate of price change in an option's value versus the rate of price changes in the underlying stock.

However, option sellers use delta to determine the probability of success. A delta of 1.0 means an option will likely move dollar-per-dollar with the underlying stock, whereas a delta of .50 means the option will move 50 cents on the dollar with the underlying stock.

An option seller would say a delta of 1.0 means you have a 100% probability the option will be at least 1 cent in the money by expiration and a .50 delta has a 50% chance the option will be 1 cent in the money by expiration. The further out of the money an option is, the higher the probability of success is when selling the option without the threat of being assigned if the contract is exercised.

At some point, option sellers have to determine how important a probability of success is compared to how much premium they are going to get from selling the option. Figure 2 shows the bid and ask prices for some option contracts. Notice the lower the delta accompanying the strike prices, the lower the premium payouts. This means an edge of some kind needs to be determined.

For instance, the example in Figure 2 also includes a different probability of expiring calculator. Various calculators are used other than delta, but this particular calculator is based on implied volatility and may give investors a much-needed edge. However, using fundamental analysis or technical analysis can also help option sellers.

Worst-Case Scenarios

Many investors refuse to sell options because they fear worst-case scenarios. The likelihood of these types of events taking place may be very small, but it is still important to know they exist.

First, selling a call option has the theoretical risk of the stock climbing to the moon. While this may be unlikely, there isn't upside protection to stop the loss if the stock rallies higher. Call sellers will thus need to determine a point at which they will choose to buy back an option contract if the stock rallies or they may implement any number of multi-leg option spread strategies designed to hedge against loss.

However, selling puts is basically the equivalent of a covered call. When selling a put, remember the risk comes with the stock falling. In other words, the put seller receives the premium and is obligated to buy the stock if its price falls below the put's strike price.

The risk for the put seller is that the option is exercised and the stock price falls to zero. However, there's not an infinite amount of risk since a stock can only hit zero and the seller gets to keep the premium as a consolation prize.

It is the same in owning a covered call. The stock could drop to zero, and the investor would lose all the money in the stock with only the call premium remaining. Similar to the selling of calls, selling puts can be protected by determining a price in which you may choose to buy back the put if the stock falls or hedge the position with a multi-leg option spread.

The Bottom Line

Selling options may not have the same kind of excitement as buying options, nor will it likely be a "home run" strategy. In fact, it's more akin to hitting single after single. Just remember, enough singles will still get you around the bases, and the score counts the same.