Nowhere in investing does the old saying "time is money" hold truer than in the options market. Indeed, options pricing includes the concept of time value. The time value of an option is the portion of its market price that vanishes into thin air as the option approaches its expiration date. It's a charge above intrinsic value that options buyers pay and options sellers collect.
Indeed, collecting that time value premium is a key reason many options sellers agree to take on the obligations associated with selling options in the first place. That raises a key question: Can you get rich selling time? The premiums can certainly be tempting, but the path to turning the concept of time value into cash in your pocket can be a rockier road than it may seem. Read on to find out how it could work and many of the traps that await you if you try.
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It's not free money
First and foremost, if you're going to sell (or write) an option to open a position, you have to understand that doing so carries with it an obligation. If you write a call option, you're agreeing to sell 100 shares per option contract at the agreed upon price on or before the expiration date of that option. If you write a put option, you're agreeing to buy 100 shares per option contract at the agreed upon price on or before the expiration date of that option.
It's only because you're taking on that obligation that the option buyer is willing to pay you that premium in the first place. If the market moves against you, you could be out a substantial amount of money -- potentially several times as much as the meager premium you received.
Indeed, writing an uncovered call option -- a short call option with no stock or long call to backstop it -- has theoretically unlimited risk attached. It's so risky that many options brokers require investors to have their highest level of options permission before being able to execute that type of strategy.
You're not guaranteed the ability to roll your options at a good value
Of course, even though any given options contract has an expiration date, any given stock that has options available will usually get new options as the existing contracts approach their expiration dates. That typically gives options sellers the opportunity to roll their obligations by buying back their existing options contract before expiration and selling new contracts with later dates. In many cases, they can even roll for a credit, receiving more cash for extending their obligations in time.
That's not always the case, however, and there are even occasions when you may be able to roll your option but wouldn't particularly want to.
For instance, say you owned 100 shares of a stock trading at $50 per share, and you sold a $55 call option against those shares. If the stock later dropped to $20 a share, would you really want to sell another call option? In that situation, a new $55 call option would likely not pay enough to be worth selling, and if you were really willing to sell at $25 (or another price point that makes sense with a $20 stock price), why didn't you accept the $50 the market was offering when you sold the first call?
If the stock moves in the opposite direction -- say leaping to $100 while you still have that $55 call written against it -- you still have that obligation to sell the shares for $55. Not only would you lose out on the additional gain, but you'd also likely find yourself in a spot where it would be difficult to roll your position for a reasonable risk/reward trade-off.
So why sell options?
Still, despite those risks, some investors do get tempted by the lure of the decaying time value to sell options. The chart below shows an example profit/loss graph based on the SPDR S&P 500 ETF Trust, using options that expire on May 28, about 30 days from this writing. The SPDR S&P 500 ETF Trust is an exchange-traded fund that attempts to track the S&P 500 index, which is often used as a proxy for the overall U.S. stock market.
The graph below shows how much money an investor could make (or lose) by selling an options position known as a strangle -- selling one call option and one put option on the SPDR S&P 500 ETF Trust. Note that this example ignores commissions for the sake of keeping the math simpler, but in reality, most investors will face some sort of commissions or fees around their options investing.
Chart by Author
On April 28, that ETF closed at $417.40. On that day, a put option expiring on May 28, 2021 at a $417 strike price could be sold for around $6.42 per share, while a call option expiring on the same date at $418 could be sold for around $6.40 per share.
Since standard options contracts involve 100 shares of stock, selling one call and one put would put $1,282 in the investor's account, in exchange for the obligations of being short the call and the put. Assuming there's no early exercise by the buyers of those options, if the ETF closes upon expiration between $417 and $418, essentially not moving at all, then neither the put nor the call will be exercised. At that point the investor would pocket the full $1,282.
Notice, however, that if the underlying price moves -- in either direction -- that investor's profit starts to shrink. Indeed, it doesn't have to move too far for that profit to become a loss. In fact, with enough volatility in the stock, it's quite easy for the investor's actual loss to become far more than the total potential gain that investor would get if everything went perfectly.
It's a high-risk way to invest
Time value is a real part of options prices, and it truly does decay away to just about $0 by the time an option expires. That makes it very tempting to try and make money selling options to collect the time value premiums. Still, that cash comes with a very real obligation and very real risks attached.
Those risks and obligations are why most brokerages restrict this type of options trading to very experienced investors. It's also why most options investors use different strategies than simply selling options to hope to profit from the decay in time value. Making money through smart options investing strategies is certainly possible, but focusing exclusively on selling options to collect the time value premiums has more risk than the reward likely justifies.
So before you jump straight in to the deep end, take some time to learn the basics of options, and build your way up to a smarter, more robust strategy. Taking a little time to learn the ropes can go a long way toward helping make you a more successful options investor overall.
This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.
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