Trading stock options within a broad investment portfolio can be an exciting experience. However, options possess particular peculiarities that separate them from other classes of investment assets. It is important to try to understand these idiosyncrasies before an investor commits money to the options market.
Below we explore one of these differences, which is the asymmetry in potential loss between buying an option and selling an option.
When buying an option, the most money you can lose is the amount you initially lay out to buy the option (the premium). If you sell options it is possible to lose much more than the premium you receive from selling the option.
A call option gives the right to buy a stock at a certain price (strike price) at some point in the future, something you do rationally if the strike price you pay when exercising the option is less than the prevailing market price of the stock. A put option gives the right to sell a stock at the strike price, something you do rationally, if this time the prevailing market of the stock is less than the strike price of the put. The premium you spend when buying the call (or put) represents the value of having the option to buy (or sell) the stock at the strike price should the market price of the stock reach the level at which it is rational to do so. If, when it comes to the time of making your choice of whether to exercise or not, the market price is at a level which means it is not rational to exercise, then you simply choose not to buy (or sell) at the strike price. The options you own will expire worthless and all you lose from this process is the premium you paid originally for the option.
When selling a call, in return for the premium received you grant someone the right to buy stock from you at some point in the future at the prescribed strike price. As before, they will do so rationally when the prevailing stock price in the market is higher than the strike price. The issue for you as the seller of the call is that, while you receive strike price when the option is exercised, if you are un-hedged, you will have to buy the stock at the prevailing market price in order to be able to deliver the shares to the owner of the call. If the price you pay when sourcing the stock exceeds the strike price of the call by more than the premium you received when selling the call, this process will leave you out of pocket. The higher the market price, the more you stand to lose; in theory, this potential loss is unlimited.The parallel problem when selling puts is that someone will rationally exercise their option to sell the stock to you when the strike price is above the market price; in effective you will receive stock that is currently worth less than the strike price you are required to pay the owner of the put. Any potential loss is determined by how far the prevailing market price is trading below the strike price on the put. In theory, the loss can be very large, but is limited as a stock price cannot fall below zero.
In short, the most you can lose when buying an option is the premium you pay (the upside is, however, unlimited); the most you can lose when selling an option is (almost) unlimited (and the upside is restricted to the option premium you receive).