I understand how buying them works but I’m looking at selling and it doesn’t seem to make sense. More importantly, what happens when they expire?
In: Economics
Think of the payoff diagram for buying calls or puts – flip it upside down and that’s the payoff for selling.
You’re receiving the option premium rather than paying it and your max upside is the premium.
edit: regarding expiry – if they expire and the option isn’t exercised by the buyer, then you keep the premium and nothing else happens. If it expires and the option is exercised, then you deliver the asset and receive the premium.
One critical difference is that if you buy a call and it ends up in the money, then either you can sell the call to someone else or you can take possession of the underlying security *at a predetermined price*. If, on the other hand, you’re selling calls, you get the sale price of the call up front, and then at expiry if the security is in the money, you’ve pre-agreed to sell at that price, which is fine *if you own the security*. This is referred to as a “covered call” because you can cover the option with securities you own.
Selling covered calls can be a good strategy for increasing your yield: If you’re holding a somewhat volatile security, that you think will close the quarter at around its current value, you can sell a call option up outside the range you think it’ll hit before expiry. If the underlying doesn’t go above that level, you’ve pocketed the option sale price, and after expiry, you can just go ahead and re-sell another call. And if the underlying does go up, you’ve still sold it up, and you can look for a new security you think is now under-priced to hold.
If, on the other hand, you don’t own the underlying security (a “naked call”) and it closes in the money, you’ll have to buy the underlying to cover the option at market price, which, since the option is in the money, is higher than expected. Your potential downside here is UNLIMITED. Never sell calls on securities that you don’t own (not that your broker is likely to let you anyway).
Options are the _option_ but not the _obligation_ to buy (or sell) some defined instrument for some set price at some date in the future.
You can buy options based on what you think the _future_ market is going to do. You can potentially lock in a cheap price on an instrument at a future date. If you think the price of stock X is going to go up, you can buy options for a low price at a future date. That will allow you to buy X at a cheap price and sell them right away for a higher price if you like. If the price doesn’t do what you think it will in the future, you can choose to not exercise your option.
Also – and least for 5 year olds – options can be used to generate _synthetic exposure_ for a portfolio. If you hold options for a contract, you can count those shares as exposure in your portfolio without paying for the actual underlying instruments. Options do have a price themselves but that price is very small. So you can spend a little bit of money to buy options, then use the option price as the value of your instruments in your portfolio. For this purpose options usually aren’t exercised, but sold and re-bought when they expire.
For instance – you want exposure to the S&P500 index but you don’t want to buy the actual stocks. You can buy options and use the option price as your exposure to S&P500 without spending the cash on actual shares. But then you have to sell and re-buy when they expire, otherwise you will no longer hold the virtual (synthetic) exposure.
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