Every option trade has a buyer and a seller. On most option platforms it is possible for traders to both buy and sell options if they wish. Selling an option is also sometimes referred to as writing an option. So far we have focused on call options from the buyers side, but it’s also important to understand the transaction from the sellers point of view as well.
Apart from any trading fees, an option contract is a zero sum game. Any profit made by a call option buyer will result in an equal loss made by the call option seller. Conversely any loss made by a call option buyer will result in an equal profit made by the call option seller.
This relationship means the profit/loss chart for the call option seller is similar to the profit/loss chart for the call option buyer, but flipped along the x-axis. Here we can see the same call option we looked at in the previous lecture, with a strike price of $30, and a premium of $3 per share.
The profit/loss of the call option buyer is shown in blue, and this time in red we can see the profit/loss of the call option seller. At each level of underlying price, the PNL lines for buyer and seller are an equal distance away from the x-axis, but on opposite sides of course, one positive and one negative.
Where each line crosses the x-axis represents the breakeven point, i.e. the point at which $0 profit or loss is made. The buyer and seller of the option share the same breakeven point as well (again, this is ignoring any trading fees).
Fixed profit
When the underlying price is below the strike price at expiry, you will remember the call option buyer has a fixed risk. For the call option seller, this means they have a fixed profit when the underlying price is below the strike price at expiry.
Unlike the buyer, the seller has a cap on their profit, and that is the premium they collected for the option. In this case $3 per share for a total of $300. No matter how low the price falls, the seller can make $300 at most.
Unlimited risk
When the underlying price increases above the strike price, the potential profit for the call option buyer is unlimited. This means the potential loss for the call option seller is also unlimited.
This is a key point because it means the call option seller can lose far more than they collected in premium, and even potentially lose everything in their trading account. For this reason it is extremely important for new traders to make themselves fully aware of the risks before selling options.
The effect of time
As the call option seller’s potential profit is capped but their potential loss is unlimited, you may be asking yourself why a trader would choose to sell a call option in the first place.
Remember from the previous lecture that there is an inherent time limit on an option. For the buyer of the call option this represents a need for the underlying price to increase sufficiently before the expiry date. So time is against the buyer.
For the seller though, the passage of time helps them. Every day that passes, the option will lose a little bit of it’s value. The more time that passes without the underlying price increasing, the more value the option will lose, and the more profit the call option seller will be making.
Put another way, if the price moves up this is bad for the call option seller, however if the price moves down or if the price does not move at all, then this is good for the call option seller. So if nothing happens, the seller is benefiting.
Margin
When buying an option, this will normally require the buyer to pay the entire premium up front to open the position. As the maximum the long call option can lose is the premium paid, this is the only capital the buyer needs to use.
In contrast the maximum loss for selling a call option is undefined. Obviously the call option seller can’t be asked to keep infinite capital in their account, but they will be asked to keep a certain amount in their trading account to support the position. This amount is called margin. Margin is an amount the broker has deemed appropriate for the trader to keep in their account to support their positions.
As the losses of selling a call could exceed this amount if the price increases significantly enough, this could leave the seller in a position where they need to add more funds to their trading account, or face having the position forcibly closed by their broker at a loss.
Once you’re experienced with options, the margin system of the trading platform you are using will be second nature to you. However, this added complexity and risk means it is advisable to stick to buying options, and at least avoid selling naked options when you’re first starting out. That is until you’re comfortable with how the margin system works and what risk is involved with selling options.
Selling a naked option means you have sold the option with no other position covering it at all. In other words there is nothing else in your account hedging that undefined risk.
In summary
Selling a call option is the complete opposite of buying a call option. Both the risk and reward are reversed. Any profit for the seller is a loss for the buyer, and vice versa.
Buying a call is a bet that the underlying price will increase, and selling a call therefore is a bet that the underlying price will not increase. Or at least not increase beyond the strike price.
The seller of a call option has a limited profit potential. Their maximum profit is the premium they collected for the call.
The seller also has undefined risk, meaning they could lose far more than they initially collected if price increases significantly. As they have undefined risk they will also need to be aware of the margin system of the site they are using.
When you’re brand new to options, it’s best to wait until you’re confident you have sufficient knowledge of the risks before selling naked options. Many sites will have paper trading or test versions of their site where you can practice trading with play money. This can be a great way to learn how the products work before risking any capital.