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Selling Options: What Every Investor Needs to Know

Last week, we took a look at a few of the strategies that investors use when buying options. Although buying options has its advantages, selling options can also be a great way to pocket some extra cash.

How does this work? Investors often write option contracts to make money during stock market lulls. Investors earn a premium for every put and call option that they sell to option buyers. When one properly, this can be a very lucrative strategy.

Today, we want to check out the best strategies for making money by selling options.

Selling Short

This is a strategy that you hear about all of the time on financial television. Market traders are always advising television viewers to short a stock. What is short selling anyway? Short selling is when you sell shares of a company that you do not own. Selling a stock short is a bet that the shares will keep going down.

Short selling is a great way to make some quick cash if you are sure that a stock’s price is going to decline.

Of course, short selling can also leave you hung out to dry if a stock increases in value after you bet against it. In a short sale you have to buy back the shares at some point. Short selling exposes you to unlimited risk.

Covered Call Strategy

A covered call strategy is great strategy for bullish investors to make some money and benefit from a stock that will move little over the short term.

Here’s how a covered call strategy works: First, you would buy 100 shares of McDonald’s at $70. Next, you would write an options contract selling one call option of McDonald’s at $70. (Remember that one call option gives an investor the right to buy 100 shares).

You would earn income because the buyer of the call option has to pay you a premium for the option. If the stock’s price drops stays below the strike price, the call buyer will never exercise the contract and the entire premium is yours to keep. If the stock’s price increases above the strike price, the call buyer may choose to exercise the contract. You would then either have to buy shares on the open market or deliver your shares to the buyer.

Cash-Secured Put Strategy

In a cash-secured put strategy, an investor would write a put contract while at the same time depositing the cash for the contract in a brokerage account.

Let’s say you think that shares of Amazon are undervalued at $110, so you decide to write a put contract on them. You would earn a premium by writing a contract selling one put option of Amazon at a strike price of $105.

If the stock’s price is higher than the strike price at expiration, the contract will just expire. If the stock drops below the strike price, the buyer would exercise the contract. You would then use the cash in your brokerage account to buy the shares of Amazon and deliver them to the buyer. The cash in the brokerage account secures the put option contract.

Bear Call Spread

A bear call spread involves selling call options at a specific strike price while simultaneously buying the exact same number of calls at a higher strike price.

Let’s say you want to set up a bear call spread when shares of Walmart are selling for $50. You would purchase a call option with a strike price of $50 for a premium of $1.00 and sell one call option with a strike price of $45 for a premium of $4.50. If the price of the stock closes below $45 upon expiration, then you would collect $350. This is the difference between the two premiums ($450 and $100).

In a bear call spread strategy, the options writer is using a decline in a stock’s price to generate income during a bear market.

Bull Call Spread

A bull call spread is the exact opposite of a bear call spread. But instead of making money selling call options, you are buying them. It involves purchasing call options at a specific strike price while simultaneously selling the same number of call options at a higher strike price. Investors employ this strategy when they are bullish on a particular stock.

When selling options, remember that although your profit potential is limited to the amount of the premium that you receive, your losses can be rather large.

Published or updated on July 15, 2010

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  1. Adam Porter says:

    Nice continuation. I’ve been dealing with Bullish and Bearish spreads, lately. My bearish spread on the Q’s is still in the green…and with more to follow as the markets turn down, I do predict.

    Fun times!

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