Selling option contracts is synonymous with shorting option contracts. We should become comfortable with using the descriptors "selling" and "short" interchangeably as most options traders do so. We already know that short call and put options expose us to additional risk compared to just buying calls and puts. The risk is harder to understand if we can't see it visually. Let's learn how to make sense of the pay-off diagrams for short calls and puts.
The inverse relationship
Instead of starting from scratch, we can lean on the knowledge we've gained from understanding pay-off diagrams for buying options.
Options are considered zero-sum
Added together, the gains and losses between option holders and sellers equal 0.
Let's revisit the concept that an options contract represents an exchange of value between two different investors. Within this contract, for every single dollar in value received by one investor, the other is losing the same amount. Understanding this inverse relationship helps us to be able to construct payoff diagrams for selling options.
Let's watch a quick video breaking this concept down.
Understanding payoff diagrams for short positions
The value diagram for a short position is not very helpful since we aren't holders of the option. Value diagrams help us see the intrinsic value and as option writers, we don't get a choice to exercise the options. In reality, we are hoping the intrinsic value stays below $0 so we can pocket the premiums.
For a short put, the concept works very similarly. Let's watch another short video.
Recall that break-even for a put is calculated differently and has to be lower than the strike price since a put option bets against the stock price.
An easy way to identify short profit diagrams is when we see one that is capped in height. For short calls and puts, the most we can stand to make is the premium collected for selling those options. The limited profit is what makes the graph vertically short. The graph also shows us that shorting options can expose us to a lot of downside risk, or the risk to lose our money. In the diagrams above, while the maximum gains are capped, the losses can be great. We'll cover the risk profile of short option positions in more detail in future lessons.