Short Options

Short options, whether they be call options or put options, are simply option contracts that you either sold or wrote. Either term is correct.

Long option positions are fairly easy to grasp, but short options can be a little confusing at first. Unlike, shorting stocks, holding a short option position doesn't by itself represent a bet on your part that a stock is going to go down. You profit on a short put position, in fact, when the stock trades higher or, at the very least, stays flat.

Let's look at a couple of quick examples to illustrate how a short option position works and why someone would want to set one up:

Example #1 - Short Call

The first example we'll use is a covered call. Imagine that you’re the lucky owner of 100 shares of The XYZ Company which is trading at $35/share. You don't necessarily want to sell the shares at the current price, and you don't think the stock is going to be moving significantly higher any time soon.

But it would be nice if you could figure out a way to squeeze a little extra profit out of your position.

You decided to sell a call option that expires in 2 months at the $40 strike price for $1.50. Since each contract represents 100 shares of the underlying stock, that equates to $150 excluding commissions. By selling the call, or writing it, you have essentially given someone else the right to purchase your stock at any point over the next two months for $40/share. In exchange, you've received $150 in cash.

If the stock is trading below $40/share at expiration, the call option you sold expires worthless and you are free to write another covered call if you so choose.

And if the stock is trading significantly higher, say $50/share? Since you were obligated to sell at $40/share, you missed out on $10/share in capital gains. In this example, you do still get a $5/share gain (selling the $35 stock for $40/share), and the original $150 premium you collected is yours to keep.

Example #2 - Short Put

Here's an example of a short put, or one that you sold or wrote instead of one you purchased. This specific trade is called a naked put.

Assume that The XYZ Zipper Company is trading at $40/share. You currently own no shares but wouldn't mind buying some if you could get them for $35/share.

You decide to sell, or write, a put option that expires in two months with a $35 strike price. In exchange, you receive a $1.50 premium ($1.50 x 100 shares = $150). If the stock never gets down to the $35/share price, the put expires worthless and you miss out on the chance to own the shares, but the $150 cash you receive is a nice compensation.

If the stock does trade below $35/share at expiration, you will be obligated to buy 100 shares for $3500. That's true whether the stock is trading at $34/share or $2/share.

The $150 in premium you received when you wrote the put is yours to kee, however, and functions as a limited buffer to the downside, in effect lowering your cost basis on the stock from $35/share to $33.50/share.