Short Sale Stock Options
- A put contract is an agreement between the option buyer and the person who writes the contract. It gives the buyer the right -- but not the obligation -- to sell a stock at a specific price on the day the contract expires. Options contracts are sold for a premium. The premium rises if the contract becomes profitable. Put buyers can profit if the price of the stock falls below the price agreed upon in the contract. For example, if you have a put contract that allows you to sell shares of IBM for $100 and IBM falls to $90, you can sell it for more money than the market will pay, making the contract valuable. You profit on the contract by selling it to someone else before it expires for a price higher than you paid.
- When a stock you buy a put contract for rises -- or at the very least does not fall -- on expiration day the contract will expire worthless. Thus, the risk of buying a put contract is the entire premium you paid. In addition, the value of the premium falls each day expiration nears. As a result, it is possible to lose money even if the stock price falls due to time decay of the contract premium if you hold the contract too long.
- When you sell a new call contract to a buyer, you are a call writer. A call contract gives the buyer the right to buy a stock at a specific price in the future. If you write a call contract, you can profit if the price declines or at least remains unchanged by the time the contract expires. For example, if you write a call contract on IBM giving the right to buy shares at $100 and the price falls to $90, the contract will expire worthless because the buyer will not likely pay $100 for a stock she can buy for $90 on the open market. In this case, you keep the premium as your profit.
- Writing call contracts on a stock you do not own is very risky. If the price of the stock rises above the price specified in the contract, you will have to sell the stock to the contract owner on expiration day. Using the previous example, if IBM rises to $120, you will have to buy IBM for $120 and sell it for $100, losing $20 per share. There is no limit to how high a stock can rise, so your risk is unlimited in this case. Of course, you can also sell a call contract on a stock you already own, which vastly reduces the risk of call writing.