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Short Selling – Selling Short Options

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Short selling or selling options short is the sale of an option which is not owned by the seller.

A short seller of calls is obligated to sell stock at the strike price by expiration if the option expires ITM.

A short seller of puts is obligated to buy stock at the strike price by expiration if the option expires ITM.

Selling options short creates a profit when the option premiums decline below the selling price.  In the case of short calls, a bearish option position (negative deltas), the option premiums will lose value (profit) as the price of the stock either declines or stagnates (time decay).  In the case of short puts, a bullish option position (positive deltas), the option premiums will lose value (profit) as the price of the underlying stock either advances or stagnates (time decay).

Short selling is the opposite of being long or buying options, and is commonly done due to the decay or time value erosion of options.

Return to the main trading glossary page to learn more terms.

Short Put – Naked Put – Option Strategies

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Selling a put short is an uncovered or naked position aiming to collect premium from the sale of the option in expectation of neutral to bullish price action.

If a short position in the underlying stock is already held, then selling a put against that short stock is known as a covered put.

Naked puts involve downside risk in the stock.  For example, if a put is sold in XYZ for $0.60 at the $20 strike, and XYZ is trading at $19 by expiration, the put has moved ITM.  The trader has the choice to either buy back the short option (for a loss since the option would be trading around $1), or get assigned a long stock position in XYZ at $20 (the strike price).  The premium collected from selling the put is kept, which effectively reduces the basis for the long stock position if assigned.  In this case, the trader would be long the stock with a basis of $19.40 ($20 strike price less $0.60 premium collected from put sale).

Short puts have a positive delta, so they are a bullish position unless paired with short stock.

Return to the main trading glossary page to learn more terms.

Short Call – Naked Call – Option Strategies

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Selling a call short is an uncovered or naked position aiming to collect premium from the sale of the option in expectation of neutral to bearish price action.

If the underlying stock is already owned, then selling a call against that long stock is known as a covered call.

Naked calls involve upside risk in the stock.  For example, if a call is sold in XYZ for $0.40 at the $25 strike, and XYZ is trading at $26 by expiration, the call has moved ITM.  The trader has the choice to either buy back the short option (for a loss since the option would be trading around $1), or get assigned a short stock position in XYZ at $25.  The premium collected from selling the call is kept, which effectively improves the basis for the short stock position if assigned.  In this case, the trader would be short the stock with a basis of $25.40 ($25 strike price plus $0.40 premium collected from call sale).

Short calls have a negative delta, so they are a bearish position unless paired with long stock.

Return to the main trading glossary page to learn more terms.

Calendar Spread – Option Strategies

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Also known as a time spread or horizontal spread, a calendar spread is a position constructed using two options of the same type (either calls or puts) where one is bought and another is sold at the same strike but for different expirations.  There are call calendar spreads and put calendar spreads.

In a calendar spread, the near-term option is sold and the back month option is bought as a hedge.  Because the back month option being bought has more time value than the near-term option being sold, a calendar spread is done for a debit.

The aim is to collect the faster decay from the short-dated option since time value erodes more quickly than in the back month option.  These are commonly used when price is expected to stagnate (non-directional) over the life of the near-term option, or when price is expected to move (directional) toward a particular strike by expiration.  The calendar spread expands, or gains value, as time passes while price stays near the strike price.

A trader could sell a naked call or a naked put if price were expected to stagnate, but those strategies lack a hedge.  In a calendar spread, the long back month option serves as a hedge, thereby limiting potential profits but also limiting risk.

Calendar spreads tend to retain at least some value even if price moves a considerable distance from the strike price.  This is because even once the near-term option expires, the long option (initially the back month option) still has time and therefore some value.  A calendar spread is net long vega, so it will benefit from an increase in implied volatility.

A reasonable profit target for a calendar spread is 50% above what was paid for the position, although some profitable calendar spreads never achieve this and others may exceed this target.

For example, a call calendar in XYZ at the $40 strike would include a short $40 call for the near-term expiration, and a long $40 call for the back month expiration.  If purchased for a $0.50 debit, then a reasonable profit target may be $0.75 (50% above the price paid).

Return to the main trading glossary page to learn more terms.

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