When you sell an option, you are granting certain rights to the option buyer.  The major right is the ability to force you to buy or sell stock from that option holder - at a specified price.  You know that price in advance - it's called the strike price.  The good news for you is that those rights have a limited lifetime and expire on a known date (expiration day).

But, isn't that risky?  Would you like to be forced to sell stock at $65 when it's trading at 80?
Would you truly want to buy stock at $50 when it's trading at $41?

Of course you wouldn't.  So why would anyone sell an option?

The first reason is that it doesn't always work out as I suggested above.  Much of the time the option expires worthless and you get to keep the cash that the option buyer paid. 

It's true that the result is not always going to be the optimal result, but the truth is that option writers win most of the time.  The problem is that an occasional huge loss can eliminate many gains.  So what can one do?

The answer is to limit risk.  That means owning a position that limits losses.  Fortunately that's easy to do.

For example, if you write covered calls (own stock, sell one option per 100 shares), you are never hurt by a stock price increase.  If the call owner makes you sell shares, you already own those shares, so you merely deliver them.  On occasion, you may no longer like the price that the option owner pays for the stock, but don't forget that this price appealed to you at the time the call was sold.  By owning stock, you don't have to be concerned about losing money on a rally.

As far as losing on a decline is concerned, that risk remains.  But it's the same risk faced by every stockholder and selling the option did not increase that risk.  In fact, to the extent that you collected cash when selling the option, you face less downside risk than the non-option selling stockholder.

It's similar when selling puts.  This is a strategy adopted by investors who are willing to buy stock, if it is below the strike price when expiration day arrives.  You went into this deal, knowing the a severe market decline could cost money.  The best way to reduce that risk is to buy a put option with a lower strike price than the one you sell.  That reduces your cash proceeds, but in exchange, you are guaranteed that losses cannot exceed a known level.  That's a good trade-off.

Selling option is not for everyone, but it is a viable strategy for the right investors.  Investment clubs can use option selling strategies.

Mark D Wolfinger

Expiring Monthly: The Option Traders Journal
http://www.expiringmonthly.com/