When I first started trading options, I went in full force and got lucky buying some calls. Most of my peers who begin trading start in the same place, but eventually this strategy leaves many of us losing more money than we ever won. Referring back to my last article, I went over three scenarios that can happen in the market:
- The stock price goes above your strike
- The stock price goes below your strike
- The stock price = your strike price
In these given scenarios, I revealed how long call options are only successful in 1 out of 3 of these (#1). AND in the ideal scenario, you are not always successful.
This article is going to use an analogy of selling a house, a more familiar concept, to reveal how the seller can have a successful trade in ALL of the scenarios mentioned above.
Selling A Call
To review, a call is an option which gives the owner of the contract the right to buy a stock. One of the key differences between buying and selling a call is that the buyer has the right to buy a stock, while the seller has not only the right, but the obligation to. Now let’s visualize this in terms of selling a house.
Imagine you are selling a house, and you make a deal with a buyer that allows them to put a nonrefundable deposit of 5k down to lock in a price of the house for 500k, with terms that require them to buy it within 30 days or lose their deposit.
You can see here how the deposit gives the buyer the right to purchase the house, but they do not have to- they can go somewhere else. Whereas the seller is obligated by the contract to sell this house if the buyer chooses to.
By reviewing an options contract, we can see that the concept is essentially the same. If you were to sell a call for $1 which allowed the buyer to lock in a strike price of 50, and this contract expired on a given expiration date, the similarity is obvious.
Important Note!!! An option contract represents 100 shares of stocks, and the price is a denomination of this. This reveals that the real cost of this option is $100, not $1.
Moving on, I am going to use the house analogy to explain the sellers side of the contract in the 3 scenarios mentioned earlier.
1. The value of the house goes up
Of the three, this is the worst case scenario- Imagine that a school was built nearby and consequently the value of your house increased from 500k to 550k. Although the value changed, you are still obligated to sell the house for 500k. For the sake of this example, assume the 5k deposit is not deducted, but rather added to the price of the house, making the real cost of the home 505k. With this assumption, this investment can be realized as a 45k loss (505-550). But, what if the house only rose to 503k? In this case, even though the house gained in value you still end up making money because of the nonrefundable deposit of 5k. In this scenario, we can realize a profit of 2k (505-503).
OR- The stock price goes up
Putting this all into financial terms, if you were to sell a call option for $1, for a predetermined strike price of $50 and the stock price goes up to $55, you would be facing a loss of $4. Calculation below:
strike price-stock price+option price
$50-$55+$1
=$4
**Remember that option prices represent 100 shares of stock, making this a $400 loss not $4 one.
Main point: If the stock price goes above your strike price by more than the amount you sold your call option for, you will be losing money
2. The value of the house goes down
While the first scenario favors the buyer, this one has quite the opposite affect. Now imagine, that a dumpster was built near your house, decreasing the value of your home. In this case, the buyer would choose not to go through with their contract, and you would inevitably get to keep their deposit of 5k. EASY MONEY
OR- The stock price goes below your strike price
On the trading platform, this deposit is known as premium and this premium is why many traders choose to be on the sellers side. When entering any short position, such as selling a call, you are credited the amount of the option contract- $100. If by expiration, the stock price has decreased by ANY amount (does not have to be some kind of spike in the market) the seller will realize their max profit of $100. Whereas the buyer has to bank on the stock price to significantly increase to realize this amount of profit, the seller only needs a small movement OR- no movement at all as explained in our next scenario.
Main Point: If you hold your short call option until expiration and the stock price goes below your strike price by ANY amount, you will make max profit.
3. The value of the house stays the same
If the value of the house stays the same, the buyer would realize a 5k loss, and the seller would realize a 5k profit. Why is this? If you remember from our first scenario, the 5k deposit is added on to the price of the house, making the real cost 505k. If the value of the house stays at 500k, which was the agreed upon sales price, we can see how the seller would benefit from this deal. The options market can be looked at very similarly.
OR- The strike price is equal to the current stock price
If at expiration, the stock price is equal to your chosen strike price of $50, you would realize your max profit of $100. This is because you were paid $100 when you sold the contract, and now the buyer will not be benefited by going through with it. Why would they want to buy 100 shares from you when they can get them in the market for the same price?
Main Point: If the stock price stays the same as your strike price, the seller of a call option will make max profit if held until expiration.
Main Point
After reading this article, I hope it is clear why many traders choose to sell options for premium as opposed to buying. To review this article with a few bullet point:
- A seller of a call option loses money when the stock price goes above the strike price by MORE than what the seller sold the contract for
- A seller will always win max profit if the stock price goes above the strike price by ANY amount when held until expiration
- A seller will always win max profit if the stock price stays the same as the strike price when held until expiration
An important assumption to note here is that this is the case when holding these options until expiration, and there are other factors that go into determining an options value and profit potential. As traders, we are rarely holding our options until expiration and while short strategies are seemingly the way to go, there are some environments where it would make more since to do a long strategy (buy a call).