How do you sell call and put options before having bought them?

Question

I keep reading about how people set up these complex options spread scenarios like strangle and straddle etc where they are simultaneously buying and selling calls and puts. How can you sell a call or put option before buying it? ... or am I misunderstanding the whole thing altogether?

Answer 1

This is an insightful question, and no, you're not misunderstanding things.

Parties can sell puts and calls that are either covered or uncovered. The difference in risk between a covered and an uncovered position is enormous, and all brokers control the type of trading their clients are permitted to do so as to limit and control this risk. Please bear in mind that when assignments come in from the clearing corporations, it is the broker who must make good on each deal. The brokers therefore make sure that their options clients either have covered positions or else have plenty of experience to know what they are doing plus sufficient margin to cover their positions.

Selling covered puts: short puts can only be covered by an offsetting short position in the stock, although many - myself included - calculate whether the cash to cover a possible assignment is available instead of maintaining the short stock.

Selling uncovered puts: the cash-or-margin rule above is sufficient, although - please note - it may not be sufficient for the broker, who may require ultra-high margin or prevent the uncovered sale entirely.

Please remember that the total risk in a short put sale is limited to the strike price. Example: if a 30P is assigned, the assignee - the party who sold the put - pays $30 per share. This is the maximum amount he can lose if the company later goes bankrupt.

Turning now to selling calls, these can be either covered or uncovered. They are two entirely different animals in terms of risk.

Covered calls: these are covered in the client's account by actual shares of the underlying or deliverable. If the option is exercised, the broker sells the shares out of client's account and delivers them. Risk is low. This is a conservative strategy.

Uncovered calls: this is the highest-risk strategy of all and most clients are not permitted to sell these calls. Theoretically speaking, there is no amount of margin that would be sufficient, because there is no limit to how high the stock price could go. By expiration day an in-the-money call will be assigned and the stock will have to be purchased, at whatever price.

In reality, brokers do allow experienced clients with sufficient margin to sell uncovered calls. Even though there is no specific asset to back the uncovered call, nevertheless, the client's ability to manage the position can launch the sale. This client is called a level 4 trader.

Most of the complex strategies such as the strangles and straddles you mention, not to speak of butterflies and condors, are put on by level 4 traders.

It's the old story. One can't trade until one has the experience, and one can't get the experience until one trades.

What to do? If you're really serious, you can start with writing a covered call or two. Every broker will permit this. If your brokerage house gives live options seminars, perhaps you could attend these and become acquainted with the staff who give the presentations or who will at least be on hand. The next step - and it may take some time - will be to secure the broker's permission to do a calendar or diagonal spread in calls or puts.

If you've managed to read this far, you'll notice I haven't mentioned buying long calls or long puts. That's because countless studies show that the buyers of naked calls and puts are the parties who lose money. It is the sellers of the options who make money, because they are selling time value, which decays as the option nears expiration, and so they get to sell time value repeatedly.

And, in selling time value, the experienced traders segue into the complex strategies you mention, in order to hedge their own risks.

If you haven't visited www.888options.com, perhaps you'd like to consider this website which has excellent tutorials and educational resources. It's the clearing corporation, not a brokerage, has little or nothing to sell.

Try also cboe.com, the granddaddy of all option exchanges. The international exchange has a good educational section, and so does the Montreal exchange which you'll find at www.m-x.ca.

Options are tricky. It's a long learning process. Fun, though. Very good luck to you.

Answer 2

If you have level 3 options trading approval you can sell puts without having a short position of at least 100 shares per contract on the underlying stock (naked). Otherwise, you can do it with level 2 if you have a short position. But you need margin if you are not holding the cash to cover.

You only need level 1 to sell calls but you need to have at least 100 shares per contract of the underlying share. This is called a 'covered call'. With level 3 you can sell the call provided you have margin and have a call contract you own at a different strike. This would be called a spread. If you have level 4 approval you can sell calls without ownership of antying.. However, this strategy is very dangerous if you don't know what to do, because if they go 'in the money' you are obligated upon assignment. I sell naked puts all the time, however, I have been trading options for years. It's not bad, if you know what you are doing. I will do the following trades:

covered calls, calendar spreads, and naked puts. I will never trade naked calls. This is dangerous. I cover these strategies on my blog: http://gmoolah.blogspot. I have written two sections which you can find on my archives: 'Creating Investment Cashflow Part I and II. I will write II soon.

But if you are a novice I only recommend section I. The rest is upon mastery of option trading, and technical analysis. Without expertise in these techniques you will simply lose your shirt, or worse, your house. I have been doing this for 6 years now and have had enough losses to learn from.

Answer 3

To your question of selling before buying is a very interesting question. Actually, what you do is look into the screen or go to a broker. If someones quotes to buy for say x dollars and if you want to sell then you get into the deal. Or you can quote your sell offer and someone if interested can buy into your quote. There is no need to buy before selling.
To your first question you have two options. When you want to sell out your bought positon you make a sell at the new quoted price and vice versa for sold position ie; buy into a sold position. That is if you bought Sept IBM for 180 few days back for $4 and today or any day till expiry you can sell another position say IBM 180 for that days quoted offer. This way you would have squared off your position. Mind it that you hold the original position but the loss that can incur will be minimised by taking opposite action on a later date. The second option is run your position to expiry in which case if you have gained then conditional allotment take place where the gain you incured will be assigned to someone who is in the opposite market at expiry. In US sometimes your opposite player will be assigned the conditional sale or buy instead of anyone like him. So it is your responsibility to avoid the risk of conditional allotment by squaring of positions as you deemed you are in the money or out of money for long after taking a position.

Answer 4

you should listen to Ryan W