‘Selling options’

It has many names: going short an option, writing an option, selling an option.

An option basicly concerns a tradable contract initiated by the party going short the option. Without any party going short, there can be no options. Going short an option is no equivalent of going short stocks, in which case the shorter needs borrowing the stock to sell straight away. He ‘s counting on it to cover later at a lower price and return the stock to the lender.

Options are created ‘out of thin air’. There are professional parties selling and buying options (both call and put options) for different strike prices and expiry dates. They provide liquidity in option contracts to the market and earn their living mainly from the bid-ask spread. There may not be a bid price for options about to expire worthless. The total number of options written 'out of thin air' is the open interest. The higher the open interest, the more liquid an option contract is likely to be.

Call options

A call option contract on a stock creates the obligation for the writer to sell 100 shares of that stock at the determined strike price on or before a determined option expiry date. A call option written can be “covered” if the writer holds the underlying stock. The stock will be sold to the option holder asking for delivery. While a stock trades for a value below the strike, this won’t happen. Such call options are ‘out he money’ (OTM). Options rapidly rise in value as the stock starts quoting above the strike: the options then are ‘in the money’ (ITM).

ITM call options have an intrinsic value: (stock price – strike price). Nevertheless they usually sell for more, as there also is a time premium, depending on the time left to expiry, on volatility and on the ‘risk free’ interest rate. As the stock rises further, call options go deep ITM and the time premium gets smaller. As a time premium is small, the option holder may wish to exercise, demanding delivery of 100 shares (per contract). This is not uncommon, especially if a company pays a dividend during the time left to option expiry.

A call option writer who doesn’t own the stock, is said to have written a naked call. He expects the stock not to rise in price. If his bearish stance materializes, he collects the option premium. A variable margin will first be locked-up on the writers’ account. If you’re short a naked call and the underlying stock starts rising, there are some solutions:

·         Buy back the call option (usually at a loss),

·         Buy back the call option and write a new call option with higher strike price at some more distant date,

·         Buy the underlying stock and wait for the call option holder to demand delivery.

A call writer needs not wait for the option expiry date to close his position. If the stock has indeed dropped in value, he may choose to buy back the call options at a profit, freeing up the margin in the process (or freeing up the underlying stock position for the writer of a covered call).

Put options

A put option contract on a stock creates the obligation for the writer to buy 100 shares of that stock at the determined strike price on or before a determined option expiry date. While a stock trades for a value above the strike, no put option holder will exercise the option. Such put options are ‘out he money’ (OTM). Put options rapidly rise in value as the stock drops below the strike: the options then are ‘in the money’ (ITM).

ITM put options have an intrinsic value: (strike price – stock price). Nevertheless they usually sell for more, as there also is a time premium, depending on the time left to expiry, on volatility and on the ‘risk free’ interest rate. As the stock drops further, put options go deep ITM and the time premium gets smaller.

There is no such thing as a ‘covered put’ option. As a writer of a put option, a certain margin will be locked on your investment account. This margin may vary. It will be reduced as the stock rises and the value of the put option declines. As time goes by, the value of put options fades away and the margin locked up becomes smaller. Nevertheless option writers may want to cover (buy back written puts at a profit) to free up margin on the account. Especially if the option premium drops below a quarter, this makes sense. If you’re short a put and the stock price drops below the strike, there are a few possibilities:

·         Buy back the put option (usually at a loss),

·         Buy back the put option and write a new put option with lower strike price at some more distant date,

·         Keep your cash ready to buy 100 shares per contract at the strike price.

The first solution (swallowing your pride) is perhaps the better if you expect more bloodshed on the stock market and you badly need to cut your losses. It is an expensive solution, especially if the option has much time left to expiry.

The last solution (wait for assignment and take the stock in portfolio) shows you’re in fact bullish on that stock and consider the drop a temporary event. Yet there have again been quite a few of those ‘temporary events’ lately. Stock markets trending down are hard times for put option writers.

As stock market swoons follow in rapid succession, intermitted by short rallies (“dead cat bounces”) volatility peaks and option premia are sky rocketing. As a put writer you may realize your largest gains writing puts at or near the bottom of a bear market… which is one of the most difficult opportunities to time correctly.

Rolling through

I’m concentrating now on the combined repurchase and sale of an option. This procedure is called “rolling through” an option to a more distant expiry date. More distant options (expiring later) have a higher time value than options only a few weeks from expiry. Especially if the strike of an option (put or call) is close to the stock price, it is worth to avoid assignment (having to buy/sell) by rolling through the position. The repurchase of a near-the-money option with little time to go is not an expensive operation. The new option position written will however bring in a more important premium. The difference between the premium received and the premium paid is called the rolling yield. This is the general principle of ‘rolling through’ options.

Parallel rolls

If the option written has the same strike price as the option repurchased, you would call the operation a parallel roll through. In such case the rolling yield will be most important if the stock quotes near the strike price of the option (the options are ‘near the money’).

Diagonal rolls

If a stock has been trending up or down, you may write a new option with a different strike price. A parallel roll of a call option on a stock that has trended down may not generate a substantial revenue any longer: the ‘old’ option may be worthless, the parallel new option has a smaller time premium as it is far OTM. While bringing down the strike price closer to the current stock price, the rolling yield is enhanced. Yet, as the trend reverses, you will be assigned to deliver the stock at a lower price.

If the trend has been against you and the option is about to expire ITM, you may opt to diagonally roll through to a different strike price. Sometimes there will be a rolling loss, (rather than a yield) as you may need leaving some money on the table to sweeten the deal for the counterparty. An example:

Diagonally rolling through put options

You have written an Oct 2011 put option contract on stock X. We all witnessed the heavy stock market correction lately and your option contract is ITM. Free up some cash to buy the stock or buy back the option? Generally you can roll through your ITM option to a new series (Jan 2012) with a lower strike price. For a put option not too deep ITM with little time left to expiry a strike $1 lower, implies an option $0.60-$0.70 cheaper. A put option with the strike $1 lower and some months left to expiry may be just as expensive (as it offers protection for a longer time). If you want to roll through your put at a strike $1 lower, you may still realize a small rolling yield, provided you prolonging for three months. If you want to pinch off $2, it will be necessary to come up with some money to sweeten the deal for the counterparty. Your rolling yield will be negative, however you need to pay up much less than the difference in contract price! Moreover this operation will free up some margin as your total risk is then reduced by $200 per contract.

The premium difference between a nearby ITM put and a more distant put with lower strike increases as the stock price drops further and the nearby put goes deep ITM. In such case the delta (one of ‘the greeks’) approaches –1, whereas the delta of its more distant cousin will be closer to –0.50. So if you want to carry through such rolling operation, any further stock decline makes the rolling through more expensive.

Further reading:

Volatility persists

Nov 16, 2010

Historic volatility is calculated using a time series of index (or stock price) close values. It is defined as the standard deviation on the series of percentage day-to-day variations. When considering all day-to-day variations, we obtain one single...

Buying an option ‘in the money’

Nov 27, 2010

Some traders claim it‘s foolish, others will tell you it ‘s smart. Buying a call option ‘in the money’, you pay up the intrinsic value: the actual stock price minus the strike of the option plus a premium, mainly depending on the time left to...