Selling put and call Loss Scenario Examples
"The question you are asking concerns the exercise of a short option position.  The other replies do not appear to address this situation. Suppose that Apple is trading at $96 and you sell a put option with a strike price of $95 for some future delivery date - say August 2016.  The option contract is for 100 shares and you sell the contract for a premium of $3.20. When you sell the option your account will be credited with the premium and debited with the broker commission.  The premium you receive will be $320 = 100 x $3.20.  The commission you pay will depend on you broker. Now suppose that the price of Apple drops to $90 and your option is exercised, either on expiry or prior to expiry.  Then you would be obliged to take delivery of 100 Apple shares at the contracted option strike price of $95 costing you $9,500 plus broker commission.  If you immediately sell the Apple shares you have purchased under your contract obligations, then assuming you sell the shares at the current market price of $90 you would realise a loss of $500 ( = 100x($95-$90) )plus commission.  Since you received a premium of $320 when you sold the put option, your net loss would be $500-$320 = $180 plus any commissions paid to your broker. Now let's look at the case of selling a call option.  Again assume that the price of Apple is $96 and you sell a call option for 100 shares with a strike price of $97 for a premium of $3.60.  The premium you receive would be $360 = 100 x $3.60.  You would also be debited for commission by your broker. Now suppose that the price of Apple shares rises to $101 and your option is exercised.  Then you would be obliged to deliver 100 Apple shares to the party exercising the option at the contracted strike price of $97.  If you did not own the shares to effect delivery, then you would need to purchase those shares in the market at the current market price of $101, and then sell them to the party exercising the option at the strike price of $97.  This would realise an immediate loss of $400 = 100 x ($101-$97) plus any  commission payable.  If you did own the shares, then you would simply deliver them and possibly pay some commission or a delivery fee to your broker.  Since you received $360 when you sold the option, your net loss would be $40 = $400-$360 plus any commission and fees payable to the broker. It is important to understand that in addition to these accounting items, short option positions carry with them a ""margin"" requirement.  You will need to maintain a margin deposit to show ""good faith"" so long as the short option position is open.  If the option you have sold moves against you, then you will be called upon to put up extra margin to cover any potential losses." Here's a simple example for a put, from both sides. Assume XYZ stock trades at $200 right now.  Let's say John writes a $190 out of the money put on XYZ stock and sells this put to Abby for the premium, which is say $5. Assume the strike date, or date of settlement, is 6 months from now.  Thus Abby is long one put option and John is short one put option (the writer of the option is short the option). On settlement date, let's assume two different scenarios: (1) If the price of the stock decreases by $50, then the put that Abby bought is 'in the money'. Abby's profit can be calculated as being strike price 190 - current stock price 150 - premium paid 5 = $35 So not including any transaction fees, that is a $35 dollar return on a $5 investment. (2) If the price of the stock increases by $50, then the put that Abby bought is worthless and her loss was 100%, or her entire $5 premium.  For John, he made $5 in 6 months (in reality you need collateral and good credit to be able to write sizable option positions). See how you can only make the premium amount but your risk is the same as holding the stock when writing a put option.
"The previous answers make valid points regarding the risks, and why you can't reasonably compare trading for profit/loss to a roll of the die. This answer looks at the math instead. Your assumption: I have an equal probability to make a profit or a loss. Is incorrect, for the reasons stated in other answers. However, the answer to your question: Can I also assume that probabilistically speaking, a trader cannot do worst than random? Is ""yes"". But only because the question is flawed. Consequently it's throwing people in all directions with their answers. But quite simply, in a truly random environment the worst case scenario, no matter how improbable, is that you lose over and over again until you have nothing left. This can happen in sequential rolls of the dice AND in trading securities/bonds/whatever. You could guess wrong for every roll of the die AND all of your stock picks could become worthless. Both outcomes result in $0 (assuming you do not gamble with credit). Tell me, which $0 is ""worse""? Given the infinite number of plays that ""random"" implies, the chance of losing your entire bankroll exists in both scenarios, and that is enough by itself to make neither option ""worse"" than the other. Of course, the opposite is also true. You could only pick winners, with an unlimited upside potential, but again that could happen with either dice rolls or stock picks. It's just highly improbable. my chances cannot be worse than random and if my trading system has an edge that is greater than the percentage of the transaction that is transaction cost, then I am probabilistically likely to make a profit? Nope. This is where it all falls apart. Just because your chances of losing it all are similarly improbable, does not make you more likely to win with one method or the other. Regression to the mean, when given infinite, truly random outcomes, makes it impossible to ""have an edge"". Also, ""probabilistically"" isn't a word, but ""probably"" is." "Yes, of course there have been studies on this.  This is no more than a question about whether the options are properly priced. (If properly priced, then your strategy will not make money on average before transaction costs and will lose once transaction costs are included.  If you could make money using your strategy, on average, then the market should - and generally will - make an adjustment in the option price to compensate.) The most famous studies on this were conducted by Black and Scholes and then by Merton. This work won the Nobel Prize in 1995. Although the Black-Scholes (or Black-Scholes-Merton) equation is so well known now that people may forget it, they didn't just sit down one day and write and equation that they thought was cool. They actually derived the equation based on market factors. Beyond this ""pioneering"" work, you've got at least two branches of study.  Academics have continued to study option pricing, including but not limited to revisions to the original Black-Scholes model, and hedge funds / large trading house have ""quants"" looking at this stuff all of the time.  The former, you could look up if you want. The latter will never see the light of day because it's proprietary. If you want specific references, I think that any textbook for a quantitative finance class would be a fine place to start.  I wouldn't be surprised if you actually find your strategy as part of a homework problem. This is not to say, by the way, that I don't think you can make money with this type of trade, but your strategy will need to include more information than you've outlined here.  Choosing which information and getting your hands on it in a timely manner will be the key." A long straddle using equity would be more akin to buying a triple leveraged ETF and an inverse triple leveraged ETF, only because one side will approach zero while the other can theoretically increase to infinity, in a short time span before time decay hits in. The reason your analogy fails is because the delta is 1.0 on both sides of your trade. At the money options, a necessary requirement for a straddle, have a delta of .5 There is an options strategy that uses in the money calls and puts with a delta closer to 1.0 to create an in the money strangle. I'm not sure if it is more similar to your strategy, an analogous options strategy would be better than yours as it would not share the potential for a margin call. "I think the issue you are having is that the option value is not a ""flow"" but rather a liability that changes value over time. It is best to illustrate with a balance sheet. The $33 dollars would be the premium net of expense that you would receive from your brokerage for having shorted the options. This would be your asset. The liability is the right for the option owner (the person you sold it to) to exercise and purchase stock at a fixed price. At the moment you sold it, the ""Marked To Market"" (MTM) value of that option is $40. Hence you are at a net account value of $33-$40= $-7 which is the commission. Over time, as the price of that option changes the value of your account is simply $33 - 2*(option price)*(100) since each option contract is for 100 shares. In your example above, this implies that the option price is 20 cents. So if I were to redo the chart it would look like this If the next day the option value goes to 21 cents, your liability would now be 2*(0.21)*(100) = $42 dollars. In a sense, 2 dollars have been ""debited"" from your account to cover your potential liability. Since you also own the stock there will be a credit from that line item (not shown). At the expiry of your option, since you are selling covered calls, if you were to be exercised on, the loss on the option and the gain on the shares you own will net off. The final cost basis of the shares you sold will be adjusted by the premium you've received. You will simply be selling your shares at strike + premium per share (0.20 cents in this example)" $15 - $5 = $10 How did you possibly buy a put for less than the intrinsic value of the option, at $8.25 So we can infer that you would have had to get this put when the stock price was AT LEAST $6.75, but given the 3 months of theta left, it was likely above $7 The value of the put if the price of the underlying asset (the stock ABC) meandered between $5 - $7 would be somewhere between $10 - $8 at expiration. So you don't really stand to lose much in this scenario, and can make a decent gain in this scenario. I mean decent if you were trading stocks and were trying to beat the S&P or keep up with Warren Buffett, but a pretty poor gain since you are trading options! If the stock moves above $7 this is where the put starts to substantially lose value. "Yes, long calls, and that's a good point. Let's see... if I bought one contract at the Bid price above...          $97.13 at expiry of $96.43 option = out of the money =- option price(x100)          = $113 loss.     $97.13 at expiry of $97.00 option = out of the money =- option price(x100)          = $77 loss.     $97.13 at expiry of $97.14 option = in the money by 1-cent=$1/contract profit - option price(x100) = $1-$58          = $57 loss   The higher strike prices have much lower losses if they expire with the  underlying stock at- or near-the-money. So, they carry ""gentler"" downside potential, and are priced much higher to reflect that ""controlled"" risk potential.  That makes sense. Thanks." I frequently do this on NADEX, selling out-of-the-money binary  calls. NADEX is highly illiquid, and the bid/ask is almost always from  the market maker. Out-of-the-money binary calls lose value quickly  (NADEX daily options exist for only ~21 hours). If I place an  above-ask order, it either gets filled quickly (within a few minutes)  due to a spike in the underlying, or not at all. I compensate by  changing my price hourly.  As Joe notes, one of Black-Scholes inputs is volatility, but price  determines (implied) volatility, so this is circular. In other words, you can  treat the bid/ask prices as bid/ask volatilities. This isn't as  far-fetched as it seems:  http://www.cmegroup.com/trading/fx/volatility-quoting-fx-options.html "Suppose the stock is $41 at expiry. The graph says I will lose money. I think I paid $37.20 for (net debit) at this price. I would make money, not lose. What am I missing? The `net debit' doesn't have anything to do with your P/L graph. Your graph is also showing your profit and loss for NOW and only one expiration. Your trade has two expirations, and I don't know which one that graph is showing. That is the ""mystery"" behind that graph. Regardless, your PUTs are mitigating your loss as you would expect, if you didn't have the put you would simply lose more money at that particular price range. If you don't like that particular range then you will have to consider a different contract. it was originally a simple covered call, I added a put to protect from stock going lower.. Your strike prices are all over the place and NBIX has a contract at every whole number.... there is nothing simple about this trade. You typically won't find an ""always profitable"" combination of options. Also, changes in volatility can distort your projects greatly." I understand what you're asking for (you want to write options ON call options... essentially the second derivative of the underlying security), and I've never heard of it. That's not to say it doesn't exist (I'm sure some investment banker has cooked something like this up at some point), but if it does exist, you wouldn't be able to trade it as easily as you can a put or a LEAP. I'm also not sure you'd actually want to buy such a thing - the amount of leverage would be enormous, and you'd need a massive amount of margin/collateral.  Additionally, a small downward movement in the stock price could wipe out the entire value of your option. "I look for buying a call option only at the money, but first understand the background above: Let's suppose X stock is being traded by $10.00 and it's January The call option is being traded by $0.20 with strike $11.00 for February. (I always look for 2% prize or more) I buy 100 stocks by $10.00 each and sell the option, earning $0.20 for each X stock. I will have to deliver my stocks by $11.00 (strike value agreed). No problem for me here, I took the prize plus the gain of $1.00. (continuing from item 3) I still can sell the option for the next month with strike equal or higher than that I bought. For instance, I can sell a call option of strike $10.00 and it might be worth to deliver stocks by $10.00 and take the prize. (continuing from item 3) Probably, it won't be possible to sell a call option with strike at the price that I paid for the stock, but that's not a problem. At the end of the option life (in February), the strike was $11.00 but the stock's price is $8.00. I got the $0.20 as prize and my stocks are free for trade again. I'll sell the call option for March with strike $9.00 (taking around 2% of prize). Well, I don't want to sell my stocks by $9.00 and make loss, right? But I'm selling the call option anyway. Then I wait till the price of the stock gets near the strike value (almost ATM) and I ""re-buy"" the option sold (Example: [StockX]C9 where C means month = March) and sell again the call option with higher strike to April (Example [StockX]D10, where D means month = April) PS.: At item 9 there should be no loss between the action of ""re-buy"" and sell to roll-out to the next month. When re-buying it with the stock's price near the strike, option value for March (C9) will be lower than when selling it to April (D10). This isn't any rule to be followed, this is just a conservative (I think they call it hedge) way to handle options and stocks. Few free to make money according to your goals and your style. The perfect rule is the one that meet your expectation, don't take the generalized rules too serious." "if you buy back the now ITM calls, then you will have a short term loss. That pair of transactions is independent, from a tax perspective, of your long position (which was being used as ""collateral"" in the very case that occurred). I can see your tax situation and can see the logic of taking a short term loss to balance a short term gain.  Referring to D Stanley's answer, #2 and #3 are not the same because you are paying intrinsic value in the options and the skew in #2, whereas #3 has no intrinsic value. Of course, because you can't know the future, the stock price could move higher or lower between #2 and #3. #1 presumes the stock continues to climb." "You are likely making an assumption that the ""Short call"" part of the article you refer to isn't making: that you own the underlying stock in the first place. Rather, selling short a call has two primary cases with considerably different risk profiles. When you short-sell (or ""write"") a call option on a stock, your position can either be: covered, which means you already own the underlying stock and will simply need to deliver it if you are assigned, or else uncovered (or naked), which means you do not own the underlying stock. Writing a covered call can be a relatively conservative trade, while writing a naked call (if your broker were to permit such) can be extremely risky. Consider: With an uncovered position, should you be assigned you will be required to buy the underlying at the prevailing price. This is a very real cost — certainly not an opportunity cost. Look a little further in the article you linked, to the Option strategies section, and you will see the covered call mentioned there. That's the kind of trade you describe in your example." "Here's my attempt at ""Options for Kids"" ""Hey kid... So you have this video game that you paid $50 for that you want to sell two months from now"" ""Yes, Mr. Video Game Broker, but I want to lock in a price so I know how much to save for a new Tickle Me Elmo for my baby sister."" ""Ok, for $3, I'll sell you a 'Put' option so you can sell the game for $40 in two months."" .... One month later .... ""Hey, Mr. Video Game Broker, I can't wait to get this new Tickle Me Elmo for my little sister for Christmas, but its hard to get and I'm afraid prices will go up. I can only spend $100!"" ""Ok kid, for $4 I'll sell you a 'Call' option to buy a Tickle me Elmo on December 21st for $95. If you can find it cheaper, the option can expire, otherwise $95 is the most you will pay!""" If the buyer exercises your option, you will have to give him the stock.  If you already own the stock, the worst that can happen is you have to give him your stock, thus losing the money you spend to buy it.  So the most you can lose is what you already spent to buy the stock (minus the price the buyer paid for your option). If you don't own the stock, you will have to buy it.  But if the stock skyrockets in value, it will be very expensive to buy it.  If for instance you buy the stock when it is worth $100, sell your covered call, and the next day the stock shoots to $1000, you will lose the $100 you got from the purchase of the stock.  But if you had used a naked call, you would have to buy the stock at $1000, and you would lose $900. Since there is no limit to how high the stock can go, there is no limit to how much money you may lose. Sounds like an illiquid option, if there are actually some bidders, market makers, then sell the option at market price (market sell order). If there are not market makers then place a really low limit sell order so that you can sit at the ask in the order book. A lot of time there is off-book liquidity, so there may be a party looking for buy liquidity. You can also exercise the option to book the loss (immediately selling the shares when they get delivered to you), if this is an American style option. But if the option is worthless then it is probably significantly underwater, and you'd end up losing a lot more as you'd buy the stock at the strike price but only be able to sell at its current market value. The loss could also be increased further if there are even MORE liquidity issues in the stock.