Spark Global Limited reports:
Every option contract has two parties — the buyer and the seller.
You may be familiar with the call option.
You are buying the right, not the obligation, to buy or sell shares at a set price on a set date. But someone has to sell that right, and that’s the seller of the option.
You see, the sellers of options are the opposite of options trading. You pay them a “premium” (the price of the option) and they keep the money for taking the risk.
If the options expire worthless (i.e. the call expires below the strike price and the call expires above the strike price), their profit is the full premium.
Let’s create a hypothetical option trade to illustrate this concept. You buy the XYZ call option at the strike price of $10, which expires in two days, and pay $1 to buy the option.
The seller of the option is responsible for the other side of the transaction and sells the option to you.
They immediately withdraw $1 from their trading account. Two days passed, and when the option expired, XYZ was still trading at $9. Your option is now worthless, and the seller keeps their $1 profit.
You buy the ABC call option at the strike price of $100, and when it expires in 4 days, you pay $5 to buy the option. Once the trade takes place, the option writer collects the $5.
The option expires four days later and ABC trades at $150. Your profit is now $45 ($50 after the strike price minus the $5 premium you paid) and the option writer has lost $45 on the trade.
Note that the standard stock option is 100 shares. So when you buy the option at a premium of $2, you multiply it by 100.
The profitability of short options
Short, put or put options all refer to the same thing. You’re shorting options, which means you’re betting against the option buyer.
So when you short an option contract, your maximum loss is the same as the maximum gain the option buyer would make on an equivalent contract.
For example, let’s review the profitability of a call option contract with a strike price of $50 and a cost of $2 between the buyer and seller of options:
Maximum benefit: Unlimited: There is no limit to how much stock prices can rise.
Maximum loss: the price you paid for the option (in this case, $2.00). This is also called an insurance premium.
Choose the seller:
Maximum gain: The price at which you put the option (in this case, $2.00). This is also called an insurance premium.
Maximum loss: Unlimited: Stock prices have no upper limit.
Notice how the profits of option buyers and sellers flipped? It’s easy to understand in this case.
Remember, put options are slightly different. Here is an example of a put option contract with a price of $2 and an option buyer and seller with a strike price of $50:
Maximum gain: The minimum increase in the stock price is zero, so to get the maximum profit from the put option, you have to subtract the premium paid from the strike price. In this case, it would be $50 – $2 = $48. To get your profit in dollars, you just multiply it by 48 times 100, which is $4,800.
Maximum loss: the exact amount you pay for the option (premium). In this case, it is $2.00 * 100 = $200
Choose the seller:
Maximum return: The price at which you put the option (premium)
Maximum loss: $4,800, the same as the maximum gain for the option buyer
Short calls and short puts
Two important factors distinguish a short call from a short put. When you short a call option, the theoretical risk is infinite.
In the unlikely event that you short a stock that has risen tenfold overnight, you are in trouble.
On the other hand, when you short a put option, your maximum loss is the price of the stock. If you short a put option on a $10 stock, the most you can lose is $10 minus the premium you got.
While this may seem like a trivial difference, it makes a huge difference when you can be absolutely certain of your maximum risk.