Selling Options

In order for an options contract to exist, an investor must first write the contract, effectively giving his promise to buy or sell a particular security or commodity at a specific price. Once written, the contract is placed for sale on the market for another investor to purchase and potentially exercise. In the process, the author of the contract is said to sell the option he has written.

Call Options

Because a call option compels the author to sell a quantity of the underlying security at the option’s strike price, call options are usually bought by speculators who believe the underlying security will rise in value before the option expires. Conversely, an investor who writes a call option thinks the underlying security will either fall in value or remain flat—neither rise nor fall.

Put Options

Put options are the polar opposite of call options. The author of a put option contract is obligated to buy the underlying security at the option’s strike price, rather than sell it as with a call option. This means the author may be forced to pay a higher price for a security than it currently trades for on the market. An investor who buys a put option from an author is therefore bearish and believes the value of the underlying security will decline in value before the contract expires.

Buying a Call Option

Because buying a call option and writing a put option are both bullish positions, the question arises as to why and when a bullish investor would choose one method over the other.

When buying a call option, the buyer pays for the current premium value of the option. Before he may profit from that option, the underlying security must move strongly enough to cover his expense generated by that premium. As such, the investor encounters an immediate loss with a potential for future gain. Despite having no promise for recovering this investment, his risk is limited to the initial payment of the option’s premium.

Writing a Put Option

Writing a put option, by comparison, produces an immediate profit for the author because he receives the premium as payment from the buyer. Strategically, he hopes the security will either increase in value or will trade flat, causing the option owner to allow it to expire. Writing an option therefore produces an immediate gain with a potential for future loss. Because a stock may hypothetically climb to any value, the author of a put option bears a risk that has no defined cap and can lead to a substantial loss.