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Selling Options: Top 5 Reasons Why You Should & Shouldn’t

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Finding returns from selling options

Introduction

In the ever-evolving landscape of the stock market, investors are constantly seeking ways to optimize their portfolios and enhance returns. Most people are familiar with the tired and true methods of swing trading stock/options positions on the long or short side. However recently one of our live trading room traders approached us with a dilemma.

This trader is a long time holder of FAANG which has been working out fantastically. He wanted to earn more money with his holdings without selling out his position. How should he accomplish this? One strategy that has gained popularity in recent years is selling options on stocks that investors already hold. This approach, known as option writing, can offer both advantages and drawbacks, depending on various factors. Let’s delve into the pros and cons of this strategy to help investors make informed decisions.

Pros Of Selling Options

  • Income Generation: One of the primary advantages of selling options on stocks you own is the potential to generate additional income. By selling call options, investors receive premiums from the buyer, which can supplement their investment returns. This can be particularly appealing in sideways or bearish markets where stock prices may remain stagnant or decline.
  • Enhanced Returns: Selling options can provide investors with an opportunity to enhance their overall returns on the underlying stock. If the stock price remains below the strike price of the call option until expiration, the investor keeps the premium received, effectively increasing their return on investment.
  • Risk Mitigation: When investors sell covered call options, they are essentially reducing their downside risk on the underlying stock. The premiums received from selling options provide a cushion against potential losses, especially in volatile market conditions. This is also true for selling puts as bullish investors can bet against bears by selling puts that will make even higher returns as the value of their holdings go up.
  • Flexibility: Selling options on stocks you hold offers flexibility in managing your portfolio. Investors can choose strike prices and expiration dates that align with their investment objectives and risk tolerance. Additionally, if the stock price rises above the strike price, investors can either roll the option forward or allow the stock to be called away, depending on their outlook.
  • Portfolio Diversification: Incorporating options selling strategies into a portfolio can enhance diversification. By generating income from options premiums, investors can offset losses or enhance returns from other investments, thereby spreading risk across different asset classes.

I know what you’re thinking. Free money just for holding 100 shares of a stock? Why doesn’t everyone do this? Well that’s because writing options also comes with inherent risks and downsides. Beyond just returns you also gamble with ownership of the stock itself when you weigh the risks of being assigned. Before we go into the downsides of selling options it’s important to over what being assigned means and the gravity of such an event happening to you.

What Does It Mean To Be Assigned When Selling Options?

When you sell options, you take on certain obligations depending on the type of option you sold. Being assigned refers to the situation where the counterparty exercises their right as an option holder, resulting in the seller (you) having to fulfill your obligation as outlined in the options contract.

For call options:

  • If you sell a call option, you’re obligated to sell the underlying asset (such as a stock) at the agreed-upon strike price if the option buyer decides to exercise the option.
  • Being assigned on a short call option means you must sell the underlying asset at the strike price, regardless of the current market price.

For put options:

  • If you sell a put option, you’re obligated to buy the underlying asset at the strike price if the option buyer decides to exercise the option.
  • Being assigned on a short put option means you must buy the underlying asset at the strike price, regardless of the current market price.

Most traders never exercise a contract so they don’t think about the impilcations of exercise events. Losing your position from being assigned on calls you sold or having to buy shares from being assigned on puts you sold can be painful depending on the circumstances. With that in context let’s go over the drawbacks of option writing.

Cons Of Selling Options

  • Limited Upside Potential: One of the main drawbacks of selling covered call options is the potential limitation on upside gains. If the stock price surpasses the strike price of the call option, the investor may miss out on additional profits beyond that point, as the stock may be called away.
  • Obligation to Sell: When investors sell covered calls, they are obligated to sell the underlying stock at the strike price if the option is exercised by the buyer. This means that if the stock price rises significantly above the strike price, investors may be forced to sell their shares, potentially missing out on further upside potential.
  • Market Risk: Like any investment strategy, selling options on stocks you hold carries inherent market risk. If the stock price experiences a sharp decline, the premiums received from selling options may not be sufficient to offset the losses on the underlying stock.
  • Time and Effort: Implementing a covered call writing strategy requires time and effort for research, analysis, and monitoring of the market and individual stock positions. Investors need to stay informed about market trends, company news, and options pricing dynamics to make informed decisions.
  • Opportunity Cost: By committing capital to holding the underlying stock and selling covered call options, investors may miss out on other investment opportunities that could offer higher returns or better risk-adjusted returns.

Conclusion

In conclusion, selling options on stocks you hold can be a viable strategy for income generation, risk mitigation, and portfolio diversification. However, it is essential for investors to weigh the potential benefits against the drawbacks and consider their investment objectives, risk tolerance, and market outlook before implementing this strategy. Like any investment approach, selling options requires careful consideration, diligence, and ongoing monitoring to effectively manage risk and maximize returns.

For more options trading education check out our Youtube Channel.

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