A Guide to Writing These Derivatives To Earn Income or Hedge Your Portfolio

Reviewed by Samantha Silberstein

Options trading generated a record 48.5 million contracts per day in 2024, yet many investors are uncertain about when to sell them. Selling or writing options can generate steady income for experienced traders, but it requires understanding a key point that many novices get backward: You sell puts when you’re optimistic about a stock’s future and sell calls when you’re pessimistic.

When you sell a put option, you’re promising to buy a stock at a set price if it falls below that level—similar to how an insurance company promises to pay if your car gets damaged. In exchange, you collect a premium upfront. With call options, you’re promising to sell a stock at a certain price, even if it rises much higher.

While selling options can create consistent income, they come with significant risks that demand careful forethought. An uncovered or “naked” call option—where you don’t own the underlying stock—could theoretically lead to unlimited losses if the stock price soars. Understanding when and how to deploy these strategies is crucial for options traders—especially as they differ for calls and puts—and we guide you through what you need to know below.

Key Takeaways

• You sell put options when bullish on a stock’s prospects since you profit if the stock stays above the strike price while keeping the premium you collected.
• You sell call options when bearish on a stock’s outlook.
• “Naked” options selling carries a much higher risk than “covered” positions where you own the underlying stock as protection. That’s because you might be on the hook for buying a stock just as its price is rising more than you anticipated.
• Covered call writing can generate extra income from stocks you already own, making it one of the most popular options strategies.
• Always have an exit strategy or hedge in place before selling options since market moves against your position can lead to substantial losses.

Call vs. Put Options

Options contracts give traders different types of rights. Call options provide the right to buy an asset at a specific price within a set time frame. Put options give the opposite right—to sell an asset at a specific price within a given period.

When investors sell these contracts, they take the other side. Here are the key elements to know about each:

Selling puts: A put seller agrees to buy the asset if the put buyer wants to sell it at the agreed-upon price. This is why traders sell puts when they expect prices to rise (since they’d have to buy at a higher price than the market) and sell calls when they think prices will fall. It’s the opposite view for those buying: Traders buy put options if they anticipate that the asset price will decline.

Selling calls: A call seller commits to sell the asset if the call buyer wants to purchase it at the agreed-upon price. Traders purchase call options if they expect that the underlying asset price will rise; the one selling them expects the price to decline.

Options Terminology: Writing and Naked

In options markets, “writing” means selling an option contract. “Naked” writing means selling options without owning the underlying stock first. If the stock price shifts, you might have to buy it to make up your end of the contract; if you owned it already, this wouldn’t be necessary, nor would you face the potential losses of doing so.

While naked options writing can generate steady income when markets behave as expected, it requires significant expertise and risk management. Professional traders typically only use naked strategies as part of a broader, diversified portfolio with strict position limits and hedging rules.

Important

Many brokers restrict naked options trading to their most experienced clients because of the potential for large losses.

Selling Put Options

Investors sell naked puts when their outlook on the underlying security is that it’s going to rise; the one buying it has a bearish outlook. The purchaser pays a premium to the seller for the right to sell the shares at an agreed-upon price should the price head lower (otherwise they won’t exercise the option).

Since the premium would be kept by the seller if the price closes above the agreed-upon strike price, you can see why an investor would choose to use this type of strategy. 

Example

Suppose you want to write an option on stock ABC. The Oct. 18 95.00 put would receive a $3.00 premium fee from a put buyer. If ABC’s market price is higher than the strike price of $95.00 by Oct. 18, the put buyer won’t exercise the right to sell at $95.00 since it can be sold at a higher price on the market.

Thus, the buyer’s maximum loss is the premium, $3.00. If the market price falls below the strike price, the put seller must buy ABC shares from the put buyer at the higher strike price since the put buyer will exercise their right to sell at $95.00. Below is a chart of the profit and loss at different strike prices.

Selling Call Options

An investor would sell a naked call option if their outlook on a specific asset was that it was going to fall, as opposed to the bullish outlook of a call buyer. The purchaser of a call option pays a premium to the writer for the right to buy the underlying at an agreed-upon price should the price of the asset be above the strike price. In this case, the option seller would get to keep the premium if the price closed below the strike price.

Warning

A naked call position, if not done with enough risk management, can be disastrous since the price of a security can theoretically rise to infinity. The potential profit is limited to the price of the option’s premium while the potential losses aren’t limited at all.

Example

Suppose you wish to sell an option on stock XYZ for $70.00, believing its stock price is heading down. You’ll receive a premium of $6.20 from the call buyer. If the market price of XYZ drops below $70.00, the buyer will not exercise the call option, and your payoff will be $6.20.

If XYZ’s market price rises above $70.00, however, the call seller is obligated to sell XYZ shares to the call buyer at the lower strike price. Should the stock price continue upward, you are on the hook for buying shares of that stock even as its price increases—this is the danger of writing a naked call.

Writing Covered Calls

A covered call refers to selling call options while already owning at least the amount you’ll need to cover if the buyer exercises the contract. To execute this strategy, if you hold a long position in a stock, you would sell call options on the same stock in an attempt to generate income.

Your long position is the “cover” since you can deliver the shares if the buyer of the call option exercises the contract. If you simultaneously buy stock and write call options against that stock position, it is known as a “buy-write” transaction.

Covered call strategies can help generate profits in flat markets, and, in some scenarios, they can provide higher returns with lower risk than their underlying investments.

What Are the Risks of Selling Options?

Selling options can be risky when the market moves adversely. Selling a call option has the risk of the stock rising indefinitely. When selling a put, however, the risk comes with the stock falling, meaning that the put seller receives the premium and is obligated to buy the stock if its price falls below the put’s strike price. Traders selling both puts and calls should have an exit strategy or hedge in place to protect against losses.

When Should You Sell a Call Option?

Investors sell call options when their outlook on a specific asset is bearish, that is, they believe it will fall.

When Should You Sell a Put Option?

Investors sell put options when their outlook on the underlying security is bullish, that is, it will rise.

What Are Other Strategies That Involve Selling Options?

Traders have many different strategies that involve selling options. These include bull put spreads, which involve selling a put option while buying a lower-strike put for protection; bear call spreads, which are similar conceptually but with calls at different strike prices; iron condors, which combine both of these previous spreads to profit from a stock trading within a specific range; and calendar spreads, which involve selling near-term options while buying longer-dated ones with the same strike price, profiting from how the value of options drops in value as it nears expiration.

The Bottom Line

Selling options can generate steady income by collecting premiums, but they require careful consideration of the risks involved and the market outlook. The critical principle is straightforward: Sell puts when bullish and calls when bearish, but always with a clear exit strategy or hedge in place.

While covered call writing offers a more conservative approach by using owned stock as protection, naked options writing demands significant expertise and careful position sizing. Rather than viewing options selling as a stand-alone strategy, successful traders typically incorporate them within a broader set of strategies.

Fact checked by Stella Osoba

In 2007, Warren Buffett made a bold statement about the investment management industry that would lead to one of the most instructive wagers in financial history. His million-dollar bet not only demonstrated the power of simple investment strategies but also exposed fundamental truths about investment costs and market efficiency that remain vital for investors today.

Key Takeaways

• The legendary investor Warren Buffet famously bet $1 million that an S&P 500 index fund would outperform a basket of hedge funds over a 10-year period.
• In 2008, Tom Seides of Protégé Partners accepted the challenge.
• Buffet prevailed, with Seides conceding the bet even before the decade had finished.
• The lesson for the average investor is that low-cost index funds are likely the best long-term option.

The Challenge That Started It All

Buffett’s bet emerged from his long-standing criticism of the high-fee investment management industry. In Berkshire Hathaway’s 2005 annual report, he argued that professional active management would underperform simple, passive investing over time.

To prove his point, he publicly wagered $500,000 (later doubled to $1 million) that no investment professional could select at least five hedge funds that would collectively outperform an S&P 500 index fund over 10 years (after fees). Ted Seides of Protégé Partners accepted the challenge, setting up an almost decade-long contest that would begin on January 1, 2008.

The Performance Gap: Index Fund vs. Hedge Funds

The results were strikingly one-sided, so much so that Buffett basically claimed victory a year early. In the nine years from 2008 through 2016, Buffett’s chosen investment, the Vanguard 500 (a low-cost S&P 500 index fund), delivered an average annual return of around 7.1%. In contrast, the hedge fund portfolio selected by Protégé Partners managed only a 2.2% average annual return.

The difference in dollar terms was, perhaps, even more dramatic: a $100,000 investment in the S&P 500 index fund would have grown to approximately $185,000 in nine years, while the same amount in the hedge funds would have reached only about $121,000.

How Simple Beat Sophisticated

Buffett’s victory wasn’t just about superior returns. It was about the fundamental logic of investing. The hedge funds faced two significant headwinds: high fees and the challenge of consistent outperformance.

While the S&P 500 index fund charged minimal fees (as low as 0.03%), hedge funds typically demand both management fees (around 2% of assets) and performance fees (20% to 50% of any profits). These costs create a substantial hurdle that even skilled managers struggle to overcome.

Moreover, except for 2008, which saw a historic market crash (hedge funds can short the market, while index funds cannot), the S&P 500 outperformed the hedge fund portfolio in every single year of the bet. This is because market efficiency makes it extremely difficult for any active manager to consistently identify and exploit mispriced securities.

Lessons for the Average Investor

The bet’s outcome offers several important lessons for individual investors.

• First, it demonstrates that simplicity often trumps complexity in investing. The straightforward approach of buying and holding a diverse market index consistently outperformed sophisticated trading strategies.
• Second, it highlights the influence of investment costs. Even small differences in fees can compound into significant differences in wealth over time.
• Finally, it suggests that beating the market consistently is extraordinarily difficult, even for highly skilled professionals with vast resources and sophisticated trading strategies.

The Bottom Line

Buffett’s winning bet does more than just prove a point about hedge funds versus index funds. It provides a clear roadmap for individual investors seeking to build wealth over the long term. The victory of the simple index fund strategy suggests that most investors would be better served by focusing on low-cost, broadly diversified investments rather than seeking market-beating returns through expensive, actively managed funds. As Buffett himself concluded, long-term investors will often do best with a low-cost index fund.