Selling Options and the Free Money Fallacy

When you write options, the premium you receive is NOT equal to your investment returns.

It's only half the trade.

Many amateur traders have stumbled upon some extremely well-known strategies and think they can magically pump out returns higher than the greatest investors in the history of humankind.

And on social media, they are very vocal about it.

I’m going to explain why you should ignore them with prejudice.

Options valuation is exceedingly complex, and there are dozens of strategies from iron condors to butterflies to fig leaves.

I'm not going to get into that.

I’m going to explain this using every amateur’s two most favourite strategies:

1. Cash-secured puts

2. Covered calls

What are Options?

Options are contracts between two parties agreeing to transact at a predetermined price on or before a specific date.

They are derivatives, which means their value is "derived" from some other underlying asset, like stocks or futures.

There is a buyer and a seller.

Buyers gain the right to buy or sell the underlying asset at the predetermined price before the contract expiry date.

Sellers on the other hand are obligated to buy or sell if the buyer exercises their rights.

With most options, buyers can exercise their rights any time before the expiry date.

Buyers pay money to sellers because the "option" to take a specific action against someone who is obligated to comply is worth something.

Selling Options vs. Buying Them

When a seller writes or sells an option, the buyer pays them a premium right there and then.

And this is where amateurs get hung up - they think that premium is their investment return.

It's a component of it, but it's only half the trade.

Once they collect that premium, the seller has an open option position, much like shorting a stock.

And a lot can happen before they close it out.

Since they're selling something they didn't own, the only way to close their position before the expiry date is to buy the same contract at the current market price.

Which could be higher or lower than the premium they received.

It's the difference between the premium received and the cost to buy the contract back that determines the return on the trade - and it can be negative.

Alternatively, if the option buyer exercises their rights to buy the stock (with call options) or sell the stock (with put options), then instead of buying the contract to close their position, the seller will either have to sell the shares to the option buyer (call options) or buy the shares from the option buyer (put options) at the predetermined strike price.

Don’t worry, I’ll explain calls vs. puts more below, with examples.

Options Pricing 

The value of the contract over time depends on several variables, including the volatility of the underlying and the length of the contract.

Again, option pricing is incredibly complex. I’m just scratching the surface here.

The main variables that new option traders look at are:

• The Strike Price

This is the price at which the buyer and seller have agreed to transact. If the strike price is $100 per share, then the parties have agreed that someone can/must buy the stock at $100 per share, and the other can/must sell it at $100 per share.

• Days to Expiration (DTE)

 Each contract has an expiry date, ranging from today (0 DTE) to 2 years+. At the end of the day on this date, the contract either expires worthless or will be exercised by one of the parties.

• Volatility/Implied Volatility 

Some stocks are more volatile than others. More volatile stocks have a higher probability of hitting a given strike price, so premiums for selling volatile stocks are higher than for lower volatility stocks.

Calls and Puts

Calls

Let's start with call options since they’re a bit easier to understand.

The buyer of a call option is buying the option, but not the obligation, to buy 100 shares of a stock at a defined price before a specific date.

As I write this, shares of APPL are trading for $227.

If I think APPL is going to rise in the short term, I can either buy the shares, or I can buy a call option, which gives me the right to buy 100 shares at a certain price.

Right now, I can buy a call option that expires on July 26th (two weeks from now), with a strike price of $230, for $3.50.

If I buy this option, I will pay the seller $3.50 per share, x 100 shares = $350. The seller will get this $350 premium for selling me the option.

If the price of APPL starts going up, my contract will be worth more than $350 as it gets closer to $230 per share. If it goes down, my call option will be worth less than $350.

Let’s say that on July 26th, the price of APPL has risen to $235 per share. My options are now “in the money”, which means the market price of APPL is higher than the agreed-upon strike price.

Since there’s no time left before the contract expires, the value of the contract will be close to $5, which reflects the amount of profit I would get if I exercise my call option, buy the shares of APPL at the strike price of $230 per share, and immediately sell them on the open market for $235.

Or I can just sell the option contract for $5 per share, which is much simpler.

What happened to the call seller?

They owe me 100 shares of APPL at $230 per share.

But the market price is $235.

So they need to buy 100 shares in the open market for $23,500 and sell them to me for $23,000.

They’ve lost $500, minus the $350 in premiums I paid them for a total loss of $150.

To simplify this, they can just buy the contract back for $500, which gives them the same $150 loss.

If they owned 100 shares of APPL in their portfolio, this would be known as a “covered” call.

Instead of buying the shares in the open market, they can just give me the shares they own for $230 each.

But since APPL is $235 in this case, they would have been better off not selling me the call option in the first place, and just owning the shares.

Puts

A put is slightly harder to grasp, but fundamentally similar.

The buyer gets the right to sell 100 shares at the strike price, and the option seller is obligated to buy them.

If I think the price of APPL is going to fall before July 26th, I can either short the stock, or I can buy a put.

The $220 strike put is selling for $1.37 per share. If I buy it, I would pay the seller $137.

If by July 26th the price has dropped to $215 per share, the contract would be in the money and would be worth around $5.

That’s because I can exercise my put option, buy 100 shares of APPL at the current market price of $215 shares for $21,500, and sell them to the put seller for the strike price of $220 per share or $22,000.

My profit is $500 minus the option premium I paid of $137, for a total profit of $363.

What about the put seller?

They took in $137 when I bought the put.

But since the contract is now worth $5 per share x 100 shares = $500, they have to buy it back and take a loss of $363.

Instead, they can buy the 100 shares of APPL from me.

If they have the cash available to do this, it’s called a “cash-secured" put.

Sellers of cash-secured puts will often sell puts on stocks they wouldn’t mind owning. They claim their worst-case scenario is they get to own a stock they like at a price lower than today.

And while that’s true, it can still lead to some ugly losses.

In the example above, the put seller buys the shares for $220, but the market price is $215. What if the market price was $200 instead?

And what if it doesn’t recover?

They would be sitting on significant losses and would have been better off just waiting and using their cash to buy the stock at the lower market prices.

In the case of both calls and puts, if the seller isn’t covered by either owning the shares first (with calls) or having the cash available to buy my shares (cash-secured puts), it’s known as a “naked” trade.

Naked options carry significant risks of catastrophic loss for the seller.

Note in the examples above, I'm ignoring another important factor in options pricing known as "theta". Theta describes the "time decay" of an option's price.

As you get closer to the expiry date, the value of the contract drops because there's less time for it to hit the strike price.

I've ignored it to keep the examples simple.

The Wheel

Okay. Now that we understand a bit about options, we can review every amateur’s favourite strategy, “the wheel”.

1. Sell a cash-secured put.

2. If the stock never hits your strike, the contract expires worthless. In that case, the full premium you took in was a return on the cash you are holding to secure the put contract. If that happens, you sell another cash-secured put.

3. If the option goes in the money, and the put buyer exercises, you buy the 100 shares of APPL.

4. Then, you sell covered calls on your shares, collecting more premiums, until your call option goes in the money. You sell the APPL shares and then repeat the whole process.

On paper, this seems too good to be true.

You “wheel” in and out of holding cash, collecting premiums, owning the stock, and collecting more premiums.

Free money right?

Not even close.

Stocks are volatile.

Prices can move violently in either direction, and often do.

Most of the lifetime returns of any given stock happen on only a handful of trading days.

And the majority of stocks perform quite poorly in the long run.

Let’s say in the example above, you sell the $220 put and APPL drops to $190 per share. You bought it for $220 per share, and are selling calls against it trying to recoup your losses.

If you sell a call at the $220 strike price, the premium you receive will be a pittance. The strike price is so far away from the current price, and so unlikely to hit the strike in the short term, that no one is going to pay you much for the call option.

To get a premium that is worth the commission of selling it, you’ll need to pick a strike price much closer to the current market price, say $200.

What happens if APPL moves violently upward through your strike price?

You have to sell it for $200.

But you bought it for $220.

You’ve lost $20 per share, or $2,000, minus the premiums you took in.

And in the short term, you won’t have taken in nearly enough premiums to cover the $2,000 loss.

But let me get back to my opening statement.

I recently got into an argument with one of these amateur traders on Twitter/X who claimed that it was “easy” to generate weekly investment returns of 1%.

Weekly.

That works out to a compound annual return of 68%.

If you could compound your money at 68% annually, starting with $100,000, not only would you be the greatest investor in the history of mankind, but after only 29 short years you’d have more money than the richest person on the planet today.

In 43 years you would own all of the wealth in the world.

Over $420 TRILLION.

Before commissions and taxes, of course.

There’s a reason these strategies are known as picking up pennies in front of a steamroller.

Vocal, amateur proponents have likely never seen a significant bear market or had a trade move violently against them.

They haven't seen the steamroller.

Yet.

I think the best analogy is Nassim Taleb’s famous turkey:

When selling options, it works until it doesn’t.

And when it doesn’t, you can get your head lopped off.

Finally, given that the majority of options volume is institutional investors, these amateurs should ask themselves:

Who's taking the other side of this trade?

If I can “easily” make 1% per week like some of these people claim, who's willing to lose 1% per week being on the opposite end of this incredibly well-known and obvious investing strategy?

And why aren’t these professionals, with their vast access to talent, resources, and technology, simply printing money with these strategies?

Because there is no free lunch.

And in a market as competitive as stock options, you’re probably the turkey.