Is Selling Options Risky?

By Derek of Positively Passive Income

Whether you’ve been investing in stocks for a while or are just getting started, you’ve probably heard about options. And most likely, you’ve heard at least one story about an investor losing their shirt over an options trade gone wrong.

These kinds of stories lead investors to think that options are too risky, so they stay away from them and just focus on regular stocks or ETFs instead.

But what are options all about, and are they really as risky as people believe they are?  This post will explain how some types of options can be incredibly risky, and others, not so much.

What is an Option?

An option is a contract that gives the buyer of the option the right, but not the obligation, to buy or sell a stock at a particular price, sometime in the future.

If the buyer decides to exercise their right, the seller of the option is obligated to buy or sell the stock at the price stated in the contract.

The price stated in the contract is known as the strike price, and the contract has an expiration date, after which it is no longer valid.

The amount that the buyer of the option pays to the seller, to compensate for the benefits they receive from owning the contract, is known as the premium.

Each options contract represents 100 shares, so the buyer of a single options contract has the right to buy or sell 100 shares of the underlying stock for the strike price.

Call Options vs. Put Options

There are two primary types of options:  calls and puts.

Call Options give the buyer the right to buy a stock for the strike price, on or before the expiration date of the option.

Put Options give the buyer the right to sell a stock for the strike price, on or before the expiration date of the option.

In terms of risk level, the most that the buyer of the option can lose is the premium they pay the seller for the option. This is because the buyer is not obligated to take any further action after buying the option.

The seller of the option faces varying degrees of risk, depending on the specific type of option they are selling.  This will be discussed in more detail below.

Which Types of Options are Relatively Low-Risk for Sellers?

Covered Calls

For most investors, selling covered calls is their first foray into options.  While all investing entails some sort of risk, selling covered calls is one of the safest types of options an investor can utilize.

As discussed above, call options give the buyer the right to buy 100 shares of a stock for the strike price, on or before the expiration date.

It follows that the seller of a call option is obligated to sell 100 shares of the stock for the strike price if the buyer exercises their right to purchase the shares.

The call becomes “covered” when the seller already owns 100 shares of the stock they’re writing the options contract against. This eliminates the risk that the seller of the option is not able to procure the shares necessary to fulfill their end of the bargain, should the buyer exercise their right.

While selling covered calls eliminates the biggest risks that can occur with selling call options, it doesn’t eliminate all of the risks.

One of the risks for the covered call seller is that they might miss out on capital gains of the underlying stock.  Let’s illustrate with an example:

• Suppose Joe owns 100 shares of a hot new electric vehicle company called Super-EV-X, whose stock is trading for $50 per share.  He originally bought the stock for $20 per share.
• On April 21st, Joe decides to sell a covered call in which he agrees to sell the stock for $55 to the buyer of the option, if the price rises to that level on or before the expiration date of May 20th.  Joe receives a premium of $1.50 per share for this contract.
• Then, imagine that there’s a surprise announcement on May 10th, that sends Super-EV-X’s stock price shooting up to $100 per share.
• In this case, the buyer would exercise their right to purchase the 100 shares for $55 per share, effectively forcing Joe to sell his shares for $55.

Technically, Joe didn’t lose money, since he bought the shares for $20 originally and sold them for $55.  However, Joe missed out on the opportunity to fully participate in the capital gains of the stock, which he would have had if he didn’t sell the covered call.

Cash-Secured Puts

After covered calls, selling cash-secured puts is the next most common options trade for those just getting into options.  Like selling covered calls, selling cash-secured puts is a relatively low-risk option.

As discussed above, put options give the buyer the right to sell 100 shares of a stock for the strike price, on or before the expiration date of the option.

It follows that the buyer of a put option is obligated to buy 100 shares of the stock for the strike price if the buyer exercises their right to sell the shares.

The put becomes “cash-secured” because the seller of the option is obligated to keep enough cash in their account to cover the cost of purchasing the shares, should the buyer of the option exercise their right. The brokerage holds this cash as collateral until the option expires, or is exercised by the buyer. This eliminates the risk that the seller of the option is not able to purchase the shares necessary to fulfill their end of the bargain.

While selling cash-secured puts eliminates the biggest risks that can occur with selling put options, it doesn’t eliminate all of the risks.

One of the risks associated with selling cash-secured puts is that the price of the stock might fall to zero, yet the seller of the option is still obligated to buy 100 shares of the stock for the strike price. But arguably, this risk also applies to investors that simply buy the stock directly, rather than acquiring it via a cash-secured put.

Another risk associated with cash-secured puts is the opportunity cost of keeping cash locked up as collateral, rather than using it for more profitable purposes.  Let’s illustrate with an example:

• Tina has found a company she’d like to invest in. She believes $100 represents fair value for the stock, and it’s currently trading at $102.50 per share.
• Since Tina doesn’t want to pay more than fair value for the stock, she decides to sell a cash-secured put with a strike price of $100.
• It turns out that, after selling the option, the price of the stock continues to rise.  In fact, within a month, the price of the stock doubled.  Unfortunately, Tina missed out on these potential gains since she never actually owned the stock.
• So while Tina’s cash could have been put to work and could have captured these gains had she actually bought the stock, it was instead locked up as collateral for the cash-secured put that she sold.

Like covered calls, there is an opportunity cost to selling cash-secured puts. But in this case, the missed opportunity is the chance to actually own the stock and participate in capital gains, since the options seller isn’t guaranteed to own the stock.

Which Types of Options Are Risky for Sellers?

There are many different ways in which options can be traded.  In this section, we’ll discuss two of the riskiest types of options trades. Note that this is an advanced topic, and I won’t be able to cover all of the risks associated with these types of options trades.  Furthermore, selling the types of options I’ll be discussing in this section should only be performed by the most advanced, experienced traders.

Naked Calls

Unlike a covered call, the seller of a “naked” call doesn’t actually own the underlying shares. Naked calls are also referred to as uncovered calls.

If the stock price doesn’t move too much before the expiration date of the option, it might not be a big deal. But in some scenarios, an investor could really lose their shirt by selling even a single naked call. Let’s take an example to illustrate:

• Suppose our investor, Risky Ron, sells a naked call against his favorite stock, which is a small-cap biotech firm.
• The stock is trading for $10 per share when Ron sells the call, and he chooses a strike price of $12.50 and an expiry date of May 20th.  He receives a $0.50 per share premium for selling the option.
• In early May, the company announces unexpectedly that one of their drugs in phase 3 testing has been found to cure a common disease. This causes the price of the stock to shoot up to $2,000 per share.
• The buyer of the call is ecstatic and exercises his right to purchase the shares for $12.50 right away.
• The problem is, Risky Ron doesn’t actually own the 100 shares of the stock that he’s now obligated to sell.  Instead, he needs to purchase the shares at the current price of $2,000 per share, to sell them for just $12.50.
• With this trade, Ron has effectively lost $198,700!  This hardly seems worth it for the $50 premium he received.

While this is an extreme case, the reality is that when selling naked calls, the downside is unlimited. This is one reason why options trading is seen as very risky, and it’s a worst-case scenario that sticking with covered calls can help avoid. Though even with covered calls, in this scenario Ron would have missed out on significant capital gains.

Naked Puts

Unlike a cash-secured put, the seller of a “naked” put isn’t required by the brokerage to have 100% of the cash available to buy the underlying stock, and the cash isn’t held as collateral.

Rather than cash, a naked put requires the investor to have a margin account, which represents funds that the brokerage is willing to lend to the investor for investment purposes.

A naked put isn’t quite as risky as a naked call, since the maximum loss of a naked put would occur when the price of the underlying stock goes to zero, whereas the maximum loss of a naked call is effectively unlimited since the price of the underlying stock could go up indefinitely.

But selling naked puts is still much riskier than selling cash-secured puts. Let’s take an example to illustrate:

• Suppose our investor, Dangerous Dan, sells a naked put against a stock he’s extremely bullish about, and he believes their upcoming earnings report will be much stronger than anticipated.
• He’s so confident that he decides to sell 100 such naked puts, which gives him control over 10,000 shares.
• The stock is trading for $100 per share when Dan sells the call, and he chooses a strike price of $95 and an expiry date of May 20th.  He receives a $1.50 premium for selling the option, for a total of $15,000.
• The company reports earnings on May 8th, and unfortunately for Dan, they didn’t meet expectations, so the stock price drops to $80.
• The buyer of the put exercises the option, and Dan is required to buy 10,000 shares of the stock for $95 per share, for a total of $950,000.
• Dan turns around and sells the shares right away, for $80 per share, which gives him $800,000.
• With this trade, Dan has effectively lost $135,000!  This hardly seems worth it for the $15,000 premium he received.

Note that if this were a cash-secured put, Dan would have needed $950,000 of cash in his account to act as collateral. This is part of what makes naked puts much riskier than cash-secured puts, as the options seller can “play” with larger amounts of money that they don’t actually have.

Conclusion

In this post, we looked at some of the risks associated with selling options.  To recap:

• Selling covered calls and cash-secured puts are a relatively low-risk approach to selling options that most investors typically begin with.
• Selling naked calls and puts is much riskier, and should only be attempted by the most advanced and experienced options traders.

Brokerages use options approval levels to determine what forms of options trading a particular investor can utilize.  A brokerage typically has four options approval levels that look something like the following:

• Level 1:  Selling covered calls and cash-secured puts
• Level 2:  Buying calls and puts
• Level 3: Trading option spreads
• Level 4: Naked calls & puts

It’s more difficult to get approved for higher levels of options trading, which helps prevent less experienced investors from getting access to the highest-risk forms of options trading. Still, one should understand the risks associated with any type of options trade before using it and should work with an investment professional before risking any of their hard-earned money.

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This article was written by Derek of Positively Passive Income

 

Derek enjoys sharing his knowledge of investing and teaching others how they can become financially independent by earning passive income through dividends and selling options.