If you have educated yourself a bit about stock options and understand what it means to go long puts and calls, you also owe it to yourself to understand selling options, also known as "writing" options.
The question that comes to mind when people see the value in having covered calls and puts in their portfolio is: what is the difference between writing an option contract against stock that I am buying or shorting, versus simply buying or shorting that stock? It is an excellent question and the answer is surprisingly simple.
Let us say that you buy 100 shares of XYZ stock at $76 per share for $7600.
At the same time you write one XYZ call with a strike price of 80, whose expiration is a few months away.
For this you are paid a premium of let's say, two dollars, or a credit of $200 (two dollars times the 100 shares of XYZ that the call represents).
Here is what you gain by doing this rather than simply buying the stock: you have lowered your cost basis for the position.
That is just a fancy way of saying that the price of getting into the position for you is actually not $7600, rather it's $7400 because of the $200 that you received for writing or selling the call.
If the stock is lower than 80 by the time the option expires, you won't be called on to deliver 100 shares of XYZ (because it would never make sense for the buyer of the call to choose to exercise his right to buy the shares at 80, if the current stock price is cheaper).
In this case the option will expire worthless and you will keep the $200 premium.
The stock might take a serious downturn during this time, which will work against you since you own the stock, but the $200 premium amount that you received for writing the option will benefit your position by that amount, and down the road could make the difference between winning or losing on this trade.
You can see that this is a nice benefit for you, for simply having written the call against the stock you bought.
But what is the downside of writing this option? Well, what happens if the stock moves up? In fact, let's say that it goes to 85 before the option expires.
If the stock is over 80 you could theoretically be called on to deliver 100 shares of XYZ at 80 at any point before the option expires.
You will most certainly be called on to deliver the shares by expiration day if the stock is over 80 on that day.
So in this case, at expiry the call is exercised and you are forced to sell your shares at 80.
Now, having bought at 76, you have at least made a profit, but your profit is only two-thirds of what it would have been had you not written a call in this case ($85-$76 = $9 if you had not written the call, versus $80-$74 =$6 since you did write the call).
And what if the stock had run to $90? Then, being forced to sell at 80 means you would forfeit $10 a share.
This simple example illustrates specifically what you gain and lose by writing a covered option against stock that you buy or short, versus simply buying or shorting it.
The premium amount you received constitutes a nice insurance policy against a downturn.
But make no mistake: if you are right about buying the stock in the first place, you have put a cap on your potential gains by writing a covered call against it.
Selling options is often touted as a good way to make income, simply writing calls and puts against stock that you already own or are short, respectively.
But if one were to write options against every stock in his portfolio, the "home runs", the big winners that happen from time to time and certainly enhance the overall performance of your portfolio, would no longer occur.
Consider very carefully the likelihood that a position you take might become a very profitable one, and write options accordingly.
The question that comes to mind when people see the value in having covered calls and puts in their portfolio is: what is the difference between writing an option contract against stock that I am buying or shorting, versus simply buying or shorting that stock? It is an excellent question and the answer is surprisingly simple.
Let us say that you buy 100 shares of XYZ stock at $76 per share for $7600.
At the same time you write one XYZ call with a strike price of 80, whose expiration is a few months away.
For this you are paid a premium of let's say, two dollars, or a credit of $200 (two dollars times the 100 shares of XYZ that the call represents).
Here is what you gain by doing this rather than simply buying the stock: you have lowered your cost basis for the position.
That is just a fancy way of saying that the price of getting into the position for you is actually not $7600, rather it's $7400 because of the $200 that you received for writing or selling the call.
If the stock is lower than 80 by the time the option expires, you won't be called on to deliver 100 shares of XYZ (because it would never make sense for the buyer of the call to choose to exercise his right to buy the shares at 80, if the current stock price is cheaper).
In this case the option will expire worthless and you will keep the $200 premium.
The stock might take a serious downturn during this time, which will work against you since you own the stock, but the $200 premium amount that you received for writing the option will benefit your position by that amount, and down the road could make the difference between winning or losing on this trade.
You can see that this is a nice benefit for you, for simply having written the call against the stock you bought.
But what is the downside of writing this option? Well, what happens if the stock moves up? In fact, let's say that it goes to 85 before the option expires.
If the stock is over 80 you could theoretically be called on to deliver 100 shares of XYZ at 80 at any point before the option expires.
You will most certainly be called on to deliver the shares by expiration day if the stock is over 80 on that day.
So in this case, at expiry the call is exercised and you are forced to sell your shares at 80.
Now, having bought at 76, you have at least made a profit, but your profit is only two-thirds of what it would have been had you not written a call in this case ($85-$76 = $9 if you had not written the call, versus $80-$74 =$6 since you did write the call).
And what if the stock had run to $90? Then, being forced to sell at 80 means you would forfeit $10 a share.
This simple example illustrates specifically what you gain and lose by writing a covered option against stock that you buy or short, versus simply buying or shorting it.
The premium amount you received constitutes a nice insurance policy against a downturn.
But make no mistake: if you are right about buying the stock in the first place, you have put a cap on your potential gains by writing a covered call against it.
Selling options is often touted as a good way to make income, simply writing calls and puts against stock that you already own or are short, respectively.
But if one were to write options against every stock in his portfolio, the "home runs", the big winners that happen from time to time and certainly enhance the overall performance of your portfolio, would no longer occur.
Consider very carefully the likelihood that a position you take might become a very profitable one, and write options accordingly.