Imagine you are the seller in the long call example.
Despite XYZ rolling out a new product, you don’t think that the share price of $2,800 will rise. In fact, you’re expecting a pullback, especially since the launch of the new product is being met with a lot of criticism, with questions about usefulness and practicality.
You attempt to capitalize on the skepticism around the product release, shorting one call option at a strike price of $2950.00. You collect a premium of $10 per share for selling the call, which adds up to $1,000 in real dollar terms since you assume 100 shares of short stock risk when selling a call.
After some initial movement in both directions, the stock ends up trading below the strike price of $2,950 by the expiration date of your contract. Since this results in the option expiring OTM and worthless, you realize a profit of $1,000, the premium received from assuming the risk of 100 short shares above $2950. This amount excludes any additional costs such as commission and regulatory fees.
Prior to expiration, options will still fluctuate in value as the market moves. Even if the stock doesn’t reach $2950 in this case, you may still see an unrealized loss, if the option is trading for more than $10.00 which is what you sold it for.
Let’s assume the day after you sold the option, the stock rallied from $2800 to $2850. Maybe your option is now worth $12.00, which would mean you’d see an unrealized loss of $200, even though the option would still be worthless at expiration as it’s OTM. Keep this in mind with short and long options trades.
At expiration, the result of short options trading is pretty binary – you either keep the credit received from selling the option if it expires OTM and realize that as profit, or if the strike is ITM at expiration the option will be worth the equivalent of how far ITM it is.
For example, if the stock is at $2965 in this example, it would be worth $15.00 or $1500 in real dollar terms since the option would be $15 points ITM. You collected $10.00 upfront though, so the realized loss from closing the position would be $5 or $500 in real dollar terms.
If you did not close the position and let it expire ITM, the short call would convert to 100 short shares of stock at $2950 and you would still keep the premium received up front.
To avoid assignment or taking shares at expiration, you can roll the short call further out in time, or close the contract to end the trade.
As a long option holder, you need the stock price to rise above the strike by more than what you paid for the option to realize a profit.
With short options trades, you can absorb movement above your strike, equivalent to the credit received from selling the option before you reach your breakeven price.
