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October 25, 2010 (Revised Ed.) - by Christopher Smith
  
Stock Option Writing Basics

An introduction to stock option selling. Selling options is also referred to as option writing and generates a cash premium to the seller's account. We cover the basics of being an option writer.  

There are always two parties to an options transaction: the option buyer and the option seller.  Being a seller does not necessarily mean that you already own an option.  Remember that options are simply contracts between two parties.  One is paying to acquire rights and the other is being paid to accept an obligation.

Option sellers earn their profits by accepting obligations, in return for which they receive the cash premium from the option buyer.  If you sell or “write” an option contract you will receive a cash deposit to your account. If the option expires out-of-the-money without being exercised, your obligations under the contract expire with it and the cash premium received is yours to keep.

Selling options has become a popular way to generate monthly cash flow, with a relatively high probability of success.

Stock Option Selling Carries Risk

Recall that if you buy a call option, you have the right to buy the underlying security at the option's strike price. The option writer takes the opposite side of the transaction, however. Therefore, they have the obligation to deliver the underlying security at the strike price.

When buying a put, you acquire the right to sell the underlying security at the strike price. By selling the put option, you will take on the obligation to purchase the underlying security at the strike price.

Whenever you sell an option you are taking on an obligation. By taking on an obligation, you are taking on risk.

Option Writing: Limited Rewards And Unlimited Risk

In return for taking on the obligation to buy or sell a security, the option writer receives a cash premium. That cash premium is the only compensation the option writer will ever receive. It is a limited, finite reward.

Despite the unlimited risk, limited reward aspect of option writing it is a popular form of trading. The reason option writing is popular is because once the option is sold it immediately generates a cash deposit to your account. As time passes and the option’s expiration date nears, the time value of that option contract erodes as the expiration date approaches and the value of that option declines.

By selling out-of-the-money options the option writer starts with a relatively high probability trade.  They do not need the underlying stock price to move in order to profit.  They simply need time to pass, the expiration date to near, and their option to remain out-of-the-money.

The option writer's downfall is failing to recognize and manage the unlimited risk aspect of a short option contract.  A stock can fall in price to zero and it can climb to an infinite high.  Selling an option exposes you to the full risk of price movement in the underlying security, but only offers a relatively small potential reward in the form of a cash premium.

Making Money Being An Option Writer

We do not recommend that you start selling options without fully understanding how to manage the risks inherent in doing so. Before you are ready to begin selling option premium, you must first learn how to turn those unlimited risks into limited ones and then learn to mange those risks so that they do not turn into liabilities that out pace your profits.

Option writing can be lucrative. The primary weakness of any option writing strategy, is the fact that your returns are limited to the premium collected. If you hope to be profitable over the long term as an option writer, you must learn how to contain losses so that the incremental gains achieved are not decimated by a single adverse market turn.