There’s something appealing about writing options.
Instead of paying a premium and hoping for a strong move in the underlying stock, the option seller receives money upfront. If the option expires worthless, they keep the premium.
Do that repeatedly, and it can seem like a reliable source of income.
But there’s a reason the option buyer is prepared to hand over the premium. The option writer is accepting an obligation – and that obligation can become extremely expensive if the market makes a sudden move.
New option traders can overlook this possibility. They focus on the income they can earn without fully appreciating the true risk they’re taking to collect it…
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Suppose a trader believes a stock trading at $110 will remain above $100. So they sell a put option with a $100 strike price and collect a $5 premium.
Because a standard stock option contract represents 100 shares, that means the trader receives $500 upfront.
If the stock stays above $100 until expiration, the put expires worthless. The trader keeps the $500, and that’s it.
It seems straightforward enough. If the stock holds up, the trader can repeat the process month after month, collecting a steady stream of income.
But let’s look at the numbers to see what’s really involved.
The maximum profit the trader can make on the trade in this example is capped at the $500 premium received. Meanwhile, the potential loss is much larger if the trade moves against them.
Suppose the stock falls to $70. In this case, the trader still has to buy 100 shares at $100 – even though they’re only worth $70. That creates a $30 per-share loss. Granted, that is partly offset by the $5 premium initially collected.
The net loss is $25 per share, which comes to $2,500 on one contract. In other words, one loss could wipe out five previous winners.
What’s more, the damage can be much greater if the stock falls further or the trader has sold multiple contracts.
This uneven payoff is one of the defining characteristics of writing options. While the writer may often win, those wins are capped, while the occasional loss can be enormous.
The problem becomes even greater during calm or steadily rising markets.
When volatility is low, option premiums typically drop. That means option writers receive less premium for accepting the same underlying obligation.
Some traders try to maintain their income by taking on more risk. They might sell additional contracts or choose strike prices closer to the current market price, increasing their risk of being assigned.
However, calm markets can change in an instant.
An earnings disappointment, a surprise economic data release, or a geopolitical event can suddenly send stocks sharply lower. Volatility surges, option premiums expand, and the position can move against the option writer much faster than they expected.
The option writer may even receive a margin call, forcing them to contribute additional funds or close the position at exactly the wrong time.
That’s why collecting premium should never be confused with collecting “free” money.
I’ve traded options for more than 40 years. And I’ve learned that surviving the unexpected matters far more than squeezing every last dollar out of the market.
It’s also why when I write an option, I add another leg to create a spread. That way, I cap my potential losses.
Sure, that reduces the overall premium I receive. But I’d much rather sacrifice some profit than expose myself to a massive loss if the market moves sharply against me.
Remember – whenever you write an option, the premium you receive is payment for accepting an obligation. That could prove far more expensive than it initially appears.
Regards,
Larry Benedict
Editor, Trading With Larry Benedict
P.S. On Wednesday night, Jeff Brown and I held an emergency briefing… If you weren’t able to join us, here’s a quick recap of what you missed:
We’re making a replay available for just a short window leading up to October 7. So please don’t delay. You can watch right here.
Reading Trading With Larry Benedict will allow you to take a look into the mind of one of the market’s greatest traders. You’ll be able to recognize and take advantage of trends in the market in no time.
