Why Selling Options Works for Traders

Strategic writing of options offers several strong benefits

   

This article originally appeared on Traders Reserve.

Why Write Options

The selling of put and call options offers options trading investors a variety of benefits. The trader can collect premium, establish a long position at a specific price, and protect gains in an underlying holding. In addition, selling options offers the trader flexibility in deciding when to get out of a position. Here’s a quick primer on the four major benefits of selling options.

Income Generation – Collecting Rent

The first and most obvious of these advantages is that you collect an up-front premium. That means you get money up front for selling the right to either sell an underlying stock (puts) or buy the underlying stock (calls).

In this case consider that you are long, or hold the underlying stock or exchange-traded fund.
Selling either put or call options allow you to generate income from that holding. If you’re right about the direction of the stock you sell a put or call on, then the best-case scenario is for the options you sell to expire worthless. When this happens you get to keep the premium without having to act at all on the underlying stock. In essence, you are collecting rent on the positions you own, and you don’t have to put a dime into the property (other than your original investment). This ability to generate income from existing holdings is perhaps the biggest benefit of writing options, but they are by no means the only benefits.

Establishing Long Positions

Selling put options is a good way to get in on a stock that you wouldn’t mind owning if that stock falls to a predetermined price. For example, if you wanted to buy XYZ stock at $20 and it’s trading at $22, you could sell a $20 strike put, collect the premium, and wait for the stock to decline. If it doesn’t hit $20 before expiration, you keep the premium. If, however, the stock does fall, then you will be “put” the stock and you’ll own it anyway. In effect, you can get paid to wait for the stock to come down to the price you want to buy it at in the first place.

Keep in mind that many brokers restrict certain accounts from selling puts due to the risk involved. After all – what happens if XYZ falls to $5? As a put seller you will have to pay $20 for it. Check with your broker regarding his firm’s rules on selling puts.

Protecting Gains

If you own a stock and you’ve made some good gains in that position, it’s probably smart to think about reducing risk in that position. One way to do this is by writing (selling) a call option on that position. If you write a call on a winning position, and then the stock gets called away from you, you are forced to sell the call at that specified price — plus you’ve already collected the premium. Yes, your potential long-term upside is capped if the stock keeps going up, but when it comes to trading, banking smaller, consistent gains is the real key to accumulating big trading profits. Writing calls allow you to protect your gains while also giving those gains a little extra juice.

Flexibility to Close a Trade

When you write an option, you actually have the flexibility to close your trade at any time. That’s because all you need to do to “get out” of the obligation you’ve auctioned off to either sell an underlying stock or buy the underlying stock is to buy back the option and effectively wash out the trade. The ability to basically cancel these contracts in the open market at virtually any time provides traders the kind of flexibility needed to make sure their holdings don’t get into hot water.

This article originally appeared on Traders Reserve.


Article printed from InvestorPlace Media, http://investorplace.com/2011/04/why-selling-options-works-for-traders/.

©2014 InvestorPlace Media, LLC

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