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Selling an option

Lesson in Course: Derivatives and options (beginner, 7min )

I now know what it means to buy and exercise an option. What does it mean to sell options and when should I do it?

Most of us have seen or heard of the movie The Big Short, which tells the story of the 2008 subprime mortgage crisis. Michael Burry was an obscure investor made famous when he bet against big banks by short-selling (shorting) the stock. While financial regulators have made shorting stocks impossible for everyday investors due to the extreme risk involved, short selling options is still possible for everyday investors. If we are unintentional when we are planning to sell our options, we could be unintentionally shorting those options. Let's learn what happens when we sell an option.

KEY TAKEAWAYS:

The three takeaways for this lesson are:

  • Learn the possible outcomes when we try to sell an option
  • Be prepared for short-term-capital gains
  • Know how to avoid writing or short-selling an option contract

Knowing the difference between closing a position and writing a short position can be the difference between cashing in or losing everything.

Selling an option

Closing an option position

Typically, most traders decide to sell an option contract only after they've purchased the option previously. By doing so, they close their position.

We close our open options position by selling the contract. The new buyer of our options contract will pay us the premium for our options contract, and after we sell our contract, the contractual agreement will now be between the original seller of the contract and the new buyer. The reason for investors to close out an option position is to either take profits or cut losses early. To properly close out a position, the exact option contract must be sold. The underlying stock, the strike price, and the maturity of the contract being sold must match the call contract that was purchased.

Short term capital gains on closing

Upon closing out a contract for a profit, it's very likely we will owe short-term capital gains.

We'll need to expect and prepare for a higher tax rate after closing our options position. It's very rare for options contracts to be held over a year due to maturities and theta decay, a topic we'll cover in future lessons. Most people who trade options pay income tax on the gains in their options positions.

 

But what happens if we end up selling a call option without having bought one?

Writing an option/ shorting an option

Selling a call option contract without an existing open position is synonymous with writing the options contract or short-selling an option. 

As the writer, we:

  1. Select the underlying stock that the contract covers
  2. Determine the maturity
  3. Determine the strike price
  4. Collect the premium from the buyer
  5. Are contractually obligated to the buyer of the option to sell or buy the stock at the strike price

The risks

The risk of shorting options is that we can be assigned.

The risk of shorting a call option is significantly higher than the risk of shorting a put option. Shorting a call option exposes us to the risks of massive jumps in stock prices. Let's walk through a quick example of the risks of shorting a call. We decided to sell short a  single $25 strike call option on $GME on January 1, 2020.

Lesson of the Day: '“Dumb Money” Is on GameStop, and It's Beating Wall  Street at Its Own Game' - The New York Times

Later in the month, prices jumped up to $347 per share. The buyer of the call contract exercises and we are assigned. The buyer buys 100 shares of $GME from us at $25 per share for a total cost of $2,500 while the shares are worth $347 per share. We are looking at a loss of $32,200 ( $347 x 100 - $25 x 100). 

 

The worst-case scenario for shorting a put is that we need to buy the underlying stock at the strike price when the stock price has dropped to $0. While this is extremely unlikely, our losses would be strike price x 100. 

If we end up accidentally writing an option and want to get out of the contractual obligation, we can buy a matching option to close out of the position. For example, if we sold a call option on $F for a $9 strike with the maturity on 1/1/2021, we can buy the same call option from another writer ($9 strike, 1/1/2021 maturity) to close out our position. Experienced investors short put and call options as a way to generate income, or use the short positions within even more complex strategies. Starting out as beginners, we should avoid shorting or writing options.

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