Need help understanding selling options

Discussion in 'Options' started by TheMathDude, Dec 4, 2011.

  1. I'm rather new to options and I was hoping someone could help clear up what I don't hope is a misconception for me.

    Say the price per share in a stock is $50 and you buy 100 shares. Then you immediately sell a call with striking price $50 (in this example the striking price doesn't matter) and premium $200 (also arbitrary).

    If the stock down or stays steady you keep the shares and the premium, and the buyer goes away empty-handed.
    However, if the stock goes up and the buyer exercises, you sell your 100 shares to the buyer for $50, and still walk away with a $200 premium.
    So whichever direction the stock goes in, you win. A similar situation occurs with selling puts.

    In the case where the buyer exercises, sure, you the seller would be better off had the buyer not exercised, since you would be able to sell your stocks to the market for more, but the point is you always gain the premium no matter what. Free money.

    It seems to me like the game of options is heavily biased in favour of the seller. Seller wins all the time, but, for the buyer, the shares must move in the right direction AND they must be volatile enough in that direction.

    I'd appreciate any input, thanks
  2. MTE


    It's not free money. By selling a call option you limit your upside. If the stocks explodes to 100 then you would forgo the $5,000 profit on the shares and go away with a measly $200.

    Also, the premium of $200 you receive for the call only gives you protection for $2, if the stocks falls below 48 then you have a loss on the shares. So, essentially, your risk is almost exactly the same as just buying the shares without the upside.
  3. Thanks MTE :)
    I just have another question, is it possible for the call-seller to cancel their open position at any time by buying back the call, paying the call's premium at that time?
  4. Everyone makes money when they sell covered calls. It's free and it's yours to keep if you don't close the call before expiration.

    OTOH, you could take a beating on the long stock that you own - as much as a 100% loss - but that's only a paper loss. :D
  5. wait a minute! are you trying to tell him it's not "money for nothing and your chicks for free!?" what a negative person you are !

  6. baro-san


    You're a math dude. Google for the covered call risk graph!

    When you sell options, for having the time on your side you assume a practically unlimited risk for a limited gain. When you buy options, the time runs against you, but you take a limited risk for a potentially unlimited gain. Look at the implied volatility too!

    Trading options means making an assumption on the underlying's price and implied volatility, as well as other factors' behaviour over a determined period of time. It is more complex than trading stocks. The slippage in higher, and the liquidity is lower.

    There is no "free money" trading strategy.
  7. steven149


    I think this is what you meant: after selling the calls, your cost would be $4800. It is not free. The illusion comes from that *if* price stays below $50 at expiration date, you cost is reduced from $5000. What caused this cost savings, seems at no cost, was your question, I think. The actual cost is time to expiration and potential upward return. We would ask the question if price would drop below $48 before expiration. But we aren't sure how to answer that.

    Selling options seems have higher probability not exercised than buying. I have been trying to understand why it is so too. I think there are costs that aren't calculated (or hard to calculate) on the seller side such that it looks cheap. But it indeed is unlimited. The buy side is easier to calculate cost as he either loses the call (the least capital allocation case) or exercises the call (the most capital allocation case). His option is limited.

    We know that higher risk would seek higher return. Now we are looking at unlimited risk versus limited risk. What kind of return we are thinking about? That probably is why selling options (calls in this example) is less likely exercised.
  8. The act of selling calls doesn't have a lower probability of exercise than buying them. If ITM at expiraration, it's assigned.

    CC's have a lousy R/R profile. In a bear, you outperform the long investor by the premium received... so you take a modestly smaller beating. In a bull, you seriously underperform since your good stocks are called away and you end up with a portfolio by adverse selection.

    The only way to suceed with C's is to have better than average stock picking skills, timing and money management.
  9. Anybody remember Wade Cook?