Strategy Post - 3/9/2024 - What are Short Options and how do they work?
Hi Readers! This is the strategy post for this week, and in this post we will discuss short options. This is a heavy concept, so reviewing this post multiple times would be very beneficial. I hope you enjoy!
Before you read this post, I recommend you briefly go over last week's post to re-familiarize yourself with how long options work. Understanding that will help you understand short options with ease.
All long options are bought, so that means that someone is selling them. Just like we can buy options, we can also sell them, and that is called shorting options. When you short an option, you are selling it to someone who bought the exact same option.
Remember how you pay a premium when you buy an option? Well, that premium goes to the person who sold the option, for both calls and puts. So, in this case, when you short an option, you are the one receiving the premium from whoever bought that option. So you actually get money up front when shorting options. But how do short options actually work? Let's first take a look at how short calls work.
So short calls are simple at first, you sell a call to receive a premium from the person who bought the call. But what about what happens at expiration? Remember, when you are long a call option, you can exercise that option at expiration and purchase the underlying stock at the strike price of the option. However, the call would only be ITM and worth exercising when the underlying stock is above the strike price, and you would only make money if the stock is above the breakeven point. So, if this happens when you are SHORT the call option, you lose money. This is because the holder of the call option (person who bought the call option you sold) will buy the stock (at the strike price) from YOU, who is short the option. To meet this, you would have to buy the stock at its current price, and sell it to the holder at the strike price (which would be lower if the call option is ITM). This means you would lose money.
So, how do you make money on a call option? You make money on a call option when it expires worthless. This means that on expiration, the stock has to be under the breakeven point, so exercising the call option would be worthless for the holder of the call option. This also means you, who is short the call option, get to keep the premium which you received up front, and that is your profit on the option.
Now let's take a look at short put options. Essentially, it works the same way as short call options, as you sell a put option and you receive the premium up front from whoever bought the put option. But remember how put options are selling options? And how a long put option is ITM when the underlying stock is BELOW the strike price of the put option? So when you are short a put option, and it is ITM and the holder exercises it, you have to buy the stock at the strike price from the holder. If you sell it ack into the market you would lose money, so when the put option is ITM you would lose money when you are short it.
This shows that you would only make money on a short put option when the underlying stock is above the breakeven point of the option. This means the put option would expire worthless, and the holder would not exercise it, which also means you get to keep the premium you received upfront.
That is all for the short options strategy post, I hope you enjoyed reading and learning about short options! Since this is a heavy concept, I will give you all some time to digest this concept, and next week is when I will go delve into what the thetas are for options. I hope this post taught you something new, and I will see you in the next post!
