Options 101.2

Welcome to the second instalment of the Options 101 series. In this post we’ll be looking at why exactly you should sell options.

As you know by now, you can either buy or sell options. These different positions have very different meanings. When you buy an option, you pay a premium to the option seller. In turn you gain a right to either sell or buy shares. At the same time the option seller receives the premium and has an obligation to fulfil if the option buyer wishes to exercise his right.

So what exactly makes selling options so interesting?

If you’re new to options make sure to read the first edition of this series first, CLICK HERE.

The Five Advantages:

I will start with what I like to call ‘The Five Advantages’:

  • Theta Decay;
  • Stock Movement one, two and three;
  • Rolling out the option.

Theta Decay

Theta is one of the four ‘Option Greeks’, the others are Delta, Gamma and Vega. I will go more in depth in to all of them another time. Theta basically provides you with the Time Decay information about an option position.

As risk and reward are always coupled, you can imagine that an option with a longer duration has more risk. When a position provides more risk, the premium or reward will be higher too. But what happens when you’ve sold an option position and a day passes? It’s less likely that something crazy will happen to the underlying asset before the expiration date and thus some of the value of the option contract disappears.

Theta or Time Decay works in the favour of the option seller because everyday that passes it is a little bit more unlikely that you will have to either buy or sell shares at the end of the option period. This is just in theory though as in the meantime the stock price could change.

When the stock price won’t move at all, Time Decay will erode all the extrinsic value of the option contract day by day until the contract expires. Extrinsic value is the Time & Expectancy value. When a option has intrinsic value (You have to sell at $100 and the stock is at $105, thus the intrinsic value is $5) Theta Decay will erode all the value until of the option contract until there is just $5 of value (or premium) left.

In short: every day that passes while you have sold an option contract is in your favour, as every day the contract becomes slightly less riskier and therefore cheaper to buy back (buying back a contract closes your position).

Stock Movement one, two and three

This might sound a bit vague but it will be easy to understand, I promise. Whenever you sell an option OTM (out of the money, you are not at risk of assignment at that time) you will always have a Margin of Safety. For example:
You sell the option ABC -P 20 DEC 2019 $100. Quick refresher: this means you have to potentially buy 100 shares of the ABC company at or before the 20th of December 2019 at a cost of $100 per share.

When you sold this option, the stock price of ABC was at $110. This provides you with a margin of safety of 10%. Now we will get to the good stuff, the three market movements.

  • The stock price can go higher, perfect! The share price moves further and further away from the point where you would have to potentially buy the shares. You are not at risk of being assigned.
  • The stock price stays flat, perfect! The value of the option contract doesn’t change yet every day the Theta works for you and chips away at the option value. You are not at risk of being assigned.
  • The stock price goes down 10% or less, fine! You didn’t get the chance to close your position early as the option premium went up (as the stock came closer to $100, the risk increased), but at the end when the option expires you are not at risk of being assigned.

Rolling out the option

Yeah okay, nice and all, but what happens when the stock price decides to decline more than 10%? Well in theory you would be in trouble. Worst case scenario you’ll have to buy 100 shares for $100 a share. If the share price at that time is $90, you will realise 10.000-9.000-X loss, X is the option premium you received (you paid $10.000 for shares, could sell for $9.000 and you received let’s say 500 in option premium, so $500 loss). This is why in all scenarios, it’s important to sell options on stocks that you really wouldn’t mind owning, even for just a few weeks.

Another defence you could use is to roll out the option. This means you’re basically rolling your obligation out in front of you. Instead of having the obligation at 20 DEC 2019, you will have it for example in 19 JUN 2020.

How does one roll out the option and what are the choices you have?

Well rolling out is actually quite simple. You first make your own position neutral. You sold a put and you’ll see in your portfolio that you have a negative position or -1. To make it neutral you will buy the same put yourself, this is what we call a close buy. You buy to close the position, in this case with a loss because the value of the option contract became much higher when the stock went under your threshold.

You spend more money on buying the right than you received for selling the obligation and thus you realised a loss. The next step is to look at future options, let’s say ABC -P 19 JUN 2020 $100. As the stock price dropped, all the other options went up in value as well, so naturally the options that are further away are worth more than the option you just closed.

  1. You sold the ABC -P 20 DEC 2019 $100 for $5.00. You received $500 in premium ($5 * 100 shares).
  2. You closed (close buy / buy back) the ABC -P 20 DEC 2019 $100 for $11.00. You realised a loss of $600 at this time.
  3. You sell ABC -P 19 JUN 2020 $100 and receive $15.00. At this point you have an unrealised profit of $900.

Of course, before this profit is realised the stock will have to expire above $100 on the 19th of June. The other choice you have is that when enough time passes or that went the share price of ABC rises slightly and the option contract hits $9.00, you close the position without a profit or a loss. Naturally when the option price (or premium) keeps falling you’ll be able to realise more and more profit.

Another important possibility you have with rolling out your option is that you can average down the share price. Let’s use the same example again:

  1. You sold the ABC -P 20 DEC 2019 $100 for $5.00. You received $500 in premium ($5 * 100 shares).
  2. You closed (close buy / buy back) the ABC -P 20 DEC 2019 $100 for $11.00. You realised a loss of $600 at this time.
  3. However this time you sell ABC -P 15 DEC 2023 $75 and receive $30.00. At this point you have an unrealised profit of $2400.

This way you have rolled out your obligation as far as you could and you lowered the strike. Instead of being at risk below $100, now you’ll only be at risk below $75. This difference option duration and strike price of course create different reactions to the stock price movements. As this time you got a lot more premium and your option is further OTM (out of the money), the price of the option (the premium) will drop harder when the stock itself reaches $100 again.

I generally tend to roll out options when I will be going away from my computer a few days or when I feel like I’m at risk of being assigned. I almost always decide to roll out the option as far as I possibly can and then check at how much extra money I could make by rolling out the option and lowering the strike at the same time.

Use your portfolio as collateral

A lot of investors start out with buying stocks or ETF’s and they definitely should. Derivates like options are highly advanced products and are only suitable for people who understand not only options, but financial markets as a whole. In my case I held stocks and ETF’s for two years before I started learning about options. I worked as a broker and had to pass a few exams. When I got a 10/10 for the option exam I really noticed that I was ready for it. Of course it might’ve been easier for me as I had a lot of exposure to financial markets and education at this job.

Anyway, my portfolio at the time was around €30.000. Quickly I learned about margin too. Margin basically means that your broker or bank will use your current portfolio value as collateral for when you want to sell options. As you know, when you sell an option all involved parties would like to have some kind of indication that you can fulfil possible obligations and thus your broker will require a bit of cash or stocks in your account.

When you have margin activated on your account the broker gives you a certain ‘spending’ space. In my case it was 70% of €30.000. It depends on the securities you hold, as the broker would assess them and decide on their safety. For instance I held either Unilever or S&P 500 stocks, these were safe enough for the highest possible margin, 70%. Whenever I saw clients with weed stocks or hype stocks in general they either had no margin or way less like 30/40%.

Back to my example: €30.000 * 70% = €21.000 of ‘spending space’. It means you can sell options until the total required margin for these option positions is higher than €21.000. But be aware, the €21.000 changes as the value of your stocks can change. Also margin percentages can change in volatile markets. And when you use all of the €21.000 and it goes below zero, expect a call or message from your broker. They will kindly ask you to either sell something to open up more room in your ‘spending space’ or to put extra money in to your investment account.

I tend to keep a big chunk of this ‘spending space’ free for bad market days and rising margin duties. While your safe stocks will deliver 70% (in my brokers case) of ‘spending space’, any cash in your account will still deliver the full 100%.

The beauty of using margin in your account is that you don’t need to have a bunch of cash sitting around and doing nothing to open some option positions. Be aware however that markets change quickly, stocks can go down and required margin can go up leaving you with a negative spending space and a broker that will ask you for more money.

Possibilities with long term option premium

Whenever I have a few positions for the long term, like 2021/2023, I tend to have a lot of cash in my investment account. These long term options bring in a lot of premium which tends to sit around and do nothing. When you are careful and thoughtful you could use this cash for something else in the meanwhile.

If your ‘spending space’ allows you to use a bit more cash and you see some great opportunities in the market today, you are able to spend the money. Although you should do this extremely carefully as the money you’re using is not realised yet, its unrealised as there is still an obligation open because of that money.

In my case I’ve sold long term short and long positions (-C’s and -P’s / Calls and Puts) because I feel that these stocks will move in a certain direction. I wasn’t sure in what time frame however, so I decided to play it for the long term and collect more premium. Some of this cash has been redistributed in to beaten down Dividend Kings or other safe equities.

As you’re playing with a lot of money which hasn’t been realised I highly advise against using too much of this money for hype stocks for two reasons:

  1. Hype stocks won’t give you back 70% margin and so your spending space will deplete extremely quickly.
  2. When markets turn volatile hype stocks tend to get hit harder. The value of the stock will go down, the rest of the portfolio value might drop and required margin for open option positions might rise. A triple whammy.

I hope I provided some useful information for you. Any feedback will be hugely appreciated, thanks for reading!

Feel free to ask me anything, there are no stupid questions!
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To find more information about options CLICK HERE.

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  1. Nice post! One thing that can feel counterintuitive is seeing option premiums go up after you have sold some. But it’s not really a loss as long as it stays OTM. I sold some puts on ALB a few days ago, and then the stock price went down by another 5% or so. But oh well. I’m confident it won’t go below the strike price.

    • DutchIndependence

      Hi SD, I struggled with the same idea the first few weeks. This is also something strange to explain to new people and to my clients. After all, they see red in their portfolio, but you still might have a margin of safety of 10%. People have to see it as a missed opportunity to collect even more premium, instead of seeing it as a loss.

      Thanks for your addition to the article!


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