Selling Puts and Covered Calls: How Option Selling Really Works

Selling options means collecting a premium up front in exchange for taking on an obligation. Selling puts, selling covered calls and selling naked calls are the three most common versions, and they share one trait: the most you can make is the premium, while the most you can lose is many times larger.

Vittorio De Angelis, Velotrade's Co-Founder and Executive Chairman, spent his career on equity derivatives desks at JP Morgan, Dresdner Kleinwort and Bank of America. In the video below he walks through a trade he likes on the S&P 500, and he opens with a warning: "It's a strategy that can be profitable, but it can also be very, very dangerous." This guide unpacks his example, explains how it differs from covered calls and cash-secured puts, and puts real numbers on every scenario.

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What selling options means

An option is a contract that gives the buyer a right and the seller an obligation. When you buy an option you pay a premium for the right. When you sell (or "write") an option you receive that premium and accept the obligation.

• Selling a call obliges you to sell the underlying at the strike price if the buyer exercises.
• Selling a put obliges you to buy the underlying at the strike price if the buyer exercises.

The premium is yours to keep whatever happens. If the option expires out of the money, it is your full profit. If it expires in the money, you settle the difference (or receive or deliver the underlying), offset only by the premium.

This is the core asymmetry Vittorio stresses: "When you sell options, your upside is capped at the amount of premium in your pocket, but your downside is unlimited." For a put the loss is technically limited, because a price cannot fall below zero, but on an index or a large stock it can still be enormous compared with the premium.

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Read the transcript

Today I would like to discuss trading direction on indices and single stocks by selling options. It's a strategy that can be profitable, but it can also be very, very dangerous. So you've been warned.

When you sell options, your upside is capped at the amount of premium in your pocket, but your downside is unlimited. So beware of what you do.

Let me give an example. The S&P is trading at 7500. I can sell a September 7600 call and pocket, let's say, 50 to 60 points. That money I make upfront, and if at expiry the S&P is below 7600, I pocket the entire premium.

This is great because it actually covers two out of three scenarios. What does that mean? It means that if the S&P doesn't move, I pocket the money, because the call finishes out of the money.

If the S&P goes down, which was my original view, I make all my money from the premium, because obviously the call will expire out of the money. And I'm even covered in the scenario in which the S&P rises a little, up to 7599. Of course, on any move above 7600 the call is in the money and I start losing money.

Again, the point I want to convey is that if the market doesn't move, you're still making money. If I had sold futures and the market didn't move, I wouldn't make money. I would make money only if the market went down.

Why is the call-selling strategy dangerous? Because of course you're pocketing 50 to 60 points, but if the S&P were to rally between now and expiry to, I don't know, 8000, well, you're down 400 points. So you've got a net loss of 350 points, which obviously is a massive multiple of the premium you pocketed.

So beware. Still, the fact that you're covered in two out of three scenarios makes it, per se, an interesting strategy.

Then there are some other little things you can do if you were wrong. Let's say we reach September and the S&P is above 7600, so my calls get exercised and I'm given futures. I end up being short futures at 7600, and realistically, if I've been exercised, it means the S&P is higher than that, so I'm actually losing money.

But I can try to reduce that loss by selling puts. I sell puts on the original strike, that's what I mainly do, 7600. If the S&P were then to come back down to the 7600 level or below, of course I'd be losing money on the short put, but I have the short futures, which make up for that.

So not only do I make up my original loss, I'm also making the extra profit of the premium on the put.

I know this sounds really confusing, so you might have to work it through with a piece of paper. If you're interested, I'm very happy to do it with some graphs and some little numbers, because it might help.

It's food for thought. These strategies can be employed on most underlyings where there is an active options market, and these days option markets, especially the short-dated ones, are extremely liquid. So there are many strategies you can work on with the same frame of mind.

Again, they can be very complex strategies, and they can be very dangerous. Please reach out if you want to discuss them in further detail.

Covered calls, cash-secured puts and naked calls

The three most common option selling strategies look similar on a screen but carry very different risk. Vittorio's S&P 500 example is the third one, a naked call, so it is worth separating them clearly.

A covered call and a cash-secured put have nearly the same payoff shape (put-call parity). The naked call is different in kind: nothing you own rises to offset the loss when the market rallies.

Selling covered calls: a worked example

Say you own 100 shares of a stock trading at $100 and sell one call with a $105 strike for a $2 premium ($200 per contract). Here is your position at expiry, compared with simply holding the shares.

Illustrative numbers, before commissions and taxes.

The premium cushions small declines and lifts returns in a flat market. The cost is the capped upside: above $105 your shares are called away. Selling covered calls does not protect you from a real sell-off. At $80 you are still down $1,800, so it is a way to earn income on shares you already want to own, not a hedge.

Selling puts: a worked example

Now say the same stock trades at $100 and you sell one $95 put for $2, setting aside $9,500 in cash in case you have to buy the shares.

Illustrative numbers, before commissions and taxes.

Your breakeven is $93 (strike minus premium). Selling puts is often described as "getting paid to place a limit order": if you were happy to buy at $95, you either keep the $200 or own shares at an effective $93. The trap is selling puts on stocks you would never want to own because the premium looks rich. Rich premiums usually mean the market expects a big move.

Vittorio's example: selling a call on the S&P 500

Vittorio's trade has no shares behind it. With the S&P 500 at 7,500 he sells a September 7,600 call and collects, in his words, roughly "50 to 60 points" of premium. Using 50 points for round numbers, the breakeven at expiry is 7,650 (strike plus premium).

His point is that the trade covers "two out of three scenarios":

1. The market falls. That was his original view, and the call expires worthless. He keeps the full premium.
2. The market does nothing. The call still expires out of the money. He keeps the premium.
3. The market rises a little. Anything up to 7,600 at expiry still lets him keep the whole premium. Above 7,600 the call starts eating into the premium, and the trade becomes a net loss above 7,650.

As he explains it, "If the market doesn't move, you're still making money. If I had sold futures and the market didn't move, I wouldn't make money." A short future only pays if the price actually falls. A short call pays if the price does not rise much.

The scenario table, in points

Illustrative numbers. On E-mini S&P 500 futures options each index point is worth $50 per contract, so a 350-point loss is $17,500 per contract.

The call wins in more scenarios than the future, but gives up most of the reward when the bearish view is right: at 7,200 the future makes 300 points and the call 50. In a strong rally the call keeps losing point for point. Vittorio puts it bluntly: pocketing around 50 points and then watching the index run to 8,000 leaves "a net loss of 350 points, which obviously is a massive multiple of the premium you pocketed."

The repair: selling puts at the original strike

Vittorio also describes what he does when the trade goes wrong. His example uses options on S&P 500 futures, which deliver a futures position when exercised (in practice this applies to options on a later-dated future, such as serial or weekly options on the next quarterly contract; an option expiring with its own future simply settles in cash). (Standard SPX index options are cash-settled, so there is no assignment into a position; you simply pay the difference.)

Say September arrives with the index at 7,700. His call is exercised and he is now short a future at 7,600, already 100 points underwater, or 50 points net of the original premium. Instead of buying the future back, he sells a put at the same 7,600 strike in the next expiry. That put is 100 points out of the money; with time left to run, assume it still pays about 150 points.

Illustrative numbers, ignoring the futures basis, costs and margin.

If the market drifts back to 7,600 or below, the short put loses money but the short future makes it back, and the put premium turns a loss into a profit. That is Vittorio's point: "So not only do I make up my original loss, I'm also making the extra profit of the premium on the put."

What the table also shows is that short future plus short put at the same strike is, in effect, a new short call. The repair collects a second premium and pushes the breakeven higher, but the open-ended risk to a continuing rally is still there. Vittorio admits it "sounds really confusing" and suggests working it out "with a piece of paper", which is good advice before trying any multi-leg option position.

The real risks of selling options

The scenario tables make option selling look tidy. The risks that hurt sellers rarely show up in a single expiry table.

Assignment

US single-stock options are American-style, so a short option can be exercised early, not just at expiry. A short call is most likely to be assigned early just before an ex-dividend date, and a deep in-the-money short put can be assigned when the time value has gone. Assignment can leave you with a stock position you did not plan for, sometimes over a weekend.

Gap risk

Option sellers are exposed to moves they cannot react to: overnight, over weekends, and around earnings, central bank decisions or major data. A stop does not help if the price jumps straight past your level at the open.

Margin

Naked option selling requires a margin account and usually a high options approval level. Margin requirements rise exactly when your position is losing, and a margin call can force you to close at the worst moment.

Volatility and tail losses

When markets fall sharply, implied volatility tends to spike, raising the value of the options you are short even before the price reaches your strike. Short option strategies typically produce many small gains followed by occasional large losses, a profile that can look excellent for years before one event removes most of it. Professionals size so that the worst plausible move, not the average one, is survivable. The risk-reward ratio guide covers why a high win rate on its own says little about whether a strategy is sound.

How professionals think about option selling

On a derivatives desk, options are sold when implied volatility looks higher than the volatility likely to occur, and the directional exposure (delta) is hedged as the market moves (the institutional hedging guide explains how). For an individual trader the lessons are simpler:

• Know which version you are selling. A covered call and a naked call can show the same premium on the screen and carry completely different risk.
• Decide the exit before the entry. Pick the level at which you buy the option back, and stick to it.
• Size for the tail, not the premium. Ask what the position loses on a 10% overnight gap and whether you can live with that number.
• Only sell puts on things you would own. Assignment is part of the strategy, not a malfunction.

Expressing index and stock views without options

Velotrade does not offer options trading. Its simulated evaluations cover crypto, forex, stocks, index ETFs and commodities, so a trader with a view on the S&P 500 or a single company expresses it on the underlying itself: SPY or QQQ on the indices page, or individual names on the stocks page. The how to trade indices guide covers the mechanics.

That changes the risk conversation in a useful way. A position in the underlying has a loss you can define with a stop and a position size, and Velotrade's simulated accounts use a static maximum drawdown, a fixed floor that does not move. The open-ended, gap-driven losses that make naked option selling dangerous are exactly what that kind of hard limit forces you to plan around. If options are central to your approach, the best prop firm for options trading comparison explains which firms support them and what to watch for.

This article is educational and not investment advice. Options are complex instruments, and losses on short options can exceed the premium received many times over.