Options Selling Premium – Definition, Explanation, and Real Examples

Options

Options Selling Premium

Options selling premium is the amount an options seller receives upfront against the risk taken by the seller. Yes, you read it right. There is the selling side of options contracts as well that allows you to make gains. However, most traders aren’t aware of this side and that’s why they miss opportunities. 

So, why is it important to understand options selling premium? What options do traders and investors need to know about it? And how it may offer substantial profits? These are all important questions in the options trading arena. If you are an options trader, then you need to learn about it. Fortunately, we are going to explain all about options selling premium in today’s post. Therefore, keep reading and extend your knowledge about selling options for premium. 

What are the options?

An options contract is an agreement between two parties to complete a potential transaction on underlying security at a predetermined price. In simple words, options are financial instruments and their value depends on the value of the underlying securities such as stocks. 

Moreover, there are two sides to each option contract – the seller and the buyer. Buying an options contract means buying the right to buy or sell the underlying security at a preset price by a predetermined date. So, it is obvious that you are buying the right because someone else is selling you the right. And that someone selling the right is the writer. That said, there are two parties involved here – the buyer and the writer.

What is an option premium? 

An option premium is the amount options holders pay to buy or sell options contracts at a predetermined rate at the expiry date. In the simplest words, the current price of an options contract is the premium. Furthermore, it is the amount the seller of options contract receives when someone buys the contract. 

Now you know what an options premium is. Therefore, it is the right time to move forward to understanding options selling premium. 

Options selling premium

As we have already discussed, there are two sides or two parties involved in an options contract transaction. One party buys an options contract whereas the other sells. So, the question here is why do options holders sell options? They do so to earn options selling premium. 

Options selling premium is the premium options contract writers receive upfront. Why do sellers receive a premium? They receive a premium because of taking a risk – the risk that the price of the underlying security will increase or decrease before the contract expires. In short, options sellers make profits through options selling premium. Additionally, if the buyer doesn’t buy or sell an asset during the timeframe of the contract, the seller still has the underlying security. 

Factors affecting options selling premium

There are a number of factors that play a role in determining the options selling premium. The most important factors are;

1. Intrinsic value

The value of an options contract if it is exercised immediately is the intrinsic value of an options contract. For example, if you have a call option with a strike price of $50. It would have an intrinsic value of $10 if the current price of the underlying security is $40. Why is it so? Because the buyer of the options contract can immediately exercise his/her right to earn a profit of $10.

Now, if the price of the underlying security is higher than the strike price, it makes the price of the call options high. Conversely, if the price of the underlying security is lower than the strike price, it makes the price of the put option go higher. 

Time value

Time value means the remaining time until the contract expiry. If an options contract has more time left until its expiration date, it has more value. And therefore, it will bring more options selling premium for the writer. Why is it so? Because investors have more time to exercise their right to trade options contracts for profit. 

Conversely, if the time period is short, the buyer has less time to exercise the options contract. Therefore, the risk increases and the value of the contract declines. 

Implied volatility

If the underlying security has high volatility, the options selling premium is high. It is so because high volatility means higher possibilities of big price movements. That’s why the premium is higher if the implied volatility of the underlying security is also high. 

Contrarily, low volatility of the underlying security means low possible price movement. Therefore, the premium of options contracts with less volatile underlying security is low. 

How to make a profit by options selling premium

There is no doubt about the fact that options are pricey, especially during times of higher volatility. However, it is also a fact that options are highly rewarding. So, the question is how options traders can make profits by options selling premium? The answer is simple. The strategy is to sell another option at the same time to receive some premium. 

There are multiple ways to collect premium when selling options. Here are some strategies to capitalize on to make profits by options selling premium. 

1. Spreads

An option spread means buying a put or call option and simultaneously selling the same type of option with a different strike price. For example, you want to buy a put option. Now you want to limit your risk using spread. However, you don’t want to pay an excessive premium. You can control your downside risk by selling another put option with a lower strike price. Let’s suppose that your chosen put option at $4 costs you 20 cents. You can sell another put option with a lower strike price. Let’s say that it is a $3.50 put option that enables you to get a 10 cents premium. Thus, you are actually limiting your protection between $4 and $3.60. 

On the other hand, you can employ the same strategy when buying call options. However, you don’t protect your downside risk when it comes to call options. Rather you are looking to make profits if prices go high. In this case, you have to find a way to cheapen the entry price up and widen the window of upside potential. How will you do it? You will do it by buying a call option with a lower strike price while selling a call option with a higher strike price. For example, you can buy a call option for $5 while selling a call option for $5.5. It will give you a window of upside potential between $5 and $5.5.

2. Marginable position

A marginable position means buying an options contract and selling another type of options contract. In other words, if you buy a call option, you will sell a put option. Conversely, if you buy a put option, you will sell a call option. 

The first situation involves buying a call while selling a put option. In this case, you actually look for receiving options selling premium on put options to cheapen up call option. Whereas, it involves taking on the margin of the shot put. This strategy works perfectly when the prices of the underlying security are at a lower level. Why so? Because it limits the downside risk associated with the short put.

On the other hand, the second situation involves buying a put option while selling a call option. In this case, you look for cheapening up the downside risk. Moreover, you actually give the impression to the market that you will be comfortable selling the under security at the preset strike price if it is higher than the price at expiration. So, this strategy is suitable when the price of the underlying security is near high. Why so? Because it gives you a favorable strike price on the put option. Additionally, it also cuts the risk associated with the short-call option. 

Why is option selling premium a sound strategy? 

Firstly, options selling premium is a strategy that is very easy to execute. Secondly, selling options also ensures a higher win rate. However, it is also important to note that the risks associated with this strategy are also high. In fact, this strategy can blow up your entire portfolio if wrongly executed. Therefore it is important to be very careful. 

Moreover, options selling premium is also a strategy that offers lower gains against higher potential losses. However, gains will be significantly high when implied volatility is high. As a general rule, higher implied volatility means high options prices. This enables options sellers to collect huge premiums. 

On the flip side, if the market remains range-bound, sellers have nothing significant to get. This is because the market doesn’t make large moves and volatility remain low. So, options sellers don’t have enough to capitalize on. Therefore, it is important to consider market conditions before choosing options selling premium strategies. 

The wrap-up

Options selling premium is the premium options contract sellers receive upfront when selling options contracts. Sellers receive a premium because of the risk that the price of the underlying security will increase or decrease before the contract expires. Moreover, options sellers make profits through options selling premium. Additionally, if the buyer doesn’t buy or sell an asset during the timeframe of the contract, the seller still has the underlying security. Furthermore, there are several ways to make profits through options selling premium. However, the most common but profitable strategies are spreads and a marginable position. But, it is important for traders to consider market conditions before going on this type of trading endeavor. 

Russell Crane

Russell Crane

Russell is an Algorithmic & Technical Analyst Trader @ PatternsWizard.
His passion is to share his knowledge about TA, patterns & more. Why hope for your trading to work when you can precisely know the performance stat of every pattern?

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