With efficient markets and narrow spreads, selling options has become a very popular options trading strategy in recent years. For decades, mostly before online trading, traders primarily bought and sold stock and seldom sold options because of liquidity and margin issues.
However, times have changed. Margin requirements to sell options, especially futures options, are no longer an impediment. Moreover, options on highly traded stocks and ETFs are very liquid with spreads as wide as $0.01.
This means selling options on thousands of stocks and hundreds of futures contracts is no longer limited to professional market makers; average retail traders can take advantage of options strategies and capture premium by selling options, but should they?
Before diving into the world of selling options, there are a couple key things to consider. For starters, there are two types of options: calls and puts. Options always offer more leverage than stocks, so this is why selling them can either be decently profitable or horrifically unprofitable. Calls appreciate when the underlying stock appreciates, and puts depreciate when the underlying stock depreciates. Of course, changes in volatility can also affect the price of options, but for the most part, traders buy calls if they’re bullish and they buy puts if they’re bearish.
Therefore, selling call options is a bearish strategy and selling put options is a bullish strategy. If a trader sells to open a put option on a stock, they are taking on the obligation to purchase that stock at the short option’s strike price.
Because there is always the possibility of a market crash, selling put options is intimidating for many traders. In the world of selling options, a trader’s worst nightmare would be waking up and logging on to their trading account only to see the stock or index they just sold puts on is now trading down 70%. That would be a complete disaster for a put seller.
It is this added downside “what if” crash risk that leads traders to refrain from selling puts and look towards selling calls because stocks always crash down and never crash up, right? Evidently, this is not always the case, and this is a serious hidden risk with selling call options.
Looking at Kodak stock (KODK) offers a perfect example. The somewhat irrelevant photo company announced plans to enter the world of cryptocurrency mining on January 9th, 2018 and the stock traded up over 100% the following day – the stock doubled overnight. If a trader sold calls in Kodak stock before this announcement, they would be almost entirely wiped out and have a nauseating margin call to deal with.
With that said, calls tend to trade at a discount to puts because, in general, stocks tend to crash down, not up. Investors are typically willing to pay more for puts because of this exact reason.
Essentially, stocks don’t crash up until they do – and when they do, it’s not pretty. Looking at the S&P 500 index offers a similar example. Over the past six trading days, the S&P 500 has closed in the green every day in a row. Although this is not as dramatic as Kodak’s one-day surge, the six-day creep in the S&P 500 is the best start to a trading year in over 30 years. Needless to say, no short call traders have made any money so far in 2018.
Sure, it’s comforting for a call seller to know that if a black swan event occurred, like an impeachment or terrorist attack, and the bottom fell out of the market, that short calls would not blow up a trading portfolio. But in return for this comfort, every once in a while, selling cheap call options can result in some serious trouble, and this is the hidden an unappreciated risk of selling call options.
As always, selling options is an advanced trading strategy and it behooves all traders to learn the basics of investing before placing any short options trades.
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