The seller of the call option has the obligation to sell the underlying security at a specified price on or before a specific date.
Selling Call Options to earn premium
The seller of a call option is also known as the writer of the call options. If you are a seller of a call option, you are actually hoping that the option eventually expires worthless. This is actually also known as the Short Call strategy. As a writer of call options, you are hoping that there are no major price moves that will make your option premium increase in value. If the market fluctuates sideways and the option expires out of the money, it’s value becomes zero or worthless. If the price of the underlying security decreases, the options contract will expire worthless as well, expiring as an out of the money contract. Hence, it expires worthless in this case as well. In the above 2 cases, you have sold the option, collected the premium, and since the options expired worthless, you can keep the premium as your profit. As mentioned above, the maximum risk to a call option seller is an infinite and unlimited loss.
Potential profit and loss of call seller
A caller seller’s maximum profit potential is limited to the premium. However, the potential loss is unlimited.
When to sell call options?
A call option seller should sell when he projects the price of the underlying security to decrease. When that happens, the position can be bought at a lower price than was sold, thereby, earning a profit.
Option strategies that involve selling of call options
Several broad option strategies involve the selling of call options. Here, we will discuss a few examples of call spreads, naked call writing and covered calls.
Example of a call spreads
A call spreads strategy involves the buying of a certain number of call options contracts and simultaneously selling the same number of call options contracts, but at different exercise prices. The whole idea here is to collect premium and to limit losses.
Let’s examine an example here.
The price of facebook right now is $103.31.
You decide after some analysis that it will not go beyond $104. You sell 1 contract of November 2015 with an exercise price of $104 at a price of $3.60 and buy 1 contract of November 2015 with an exercise price $105 at a price of $3.25.
$3.60 – $3.25 = $0.35
$0.35 x 100 = $35
You stand to keep $35 of options premium if all the options expire worthless. Of course, that is a good outcome. You could still lose money if the trade goes against your predictions.
Example of a naked call
Let’s utilise the same example. You like facebook. But you believe that its stock price is not going to increase beyond $108. But instead, this time, you do not own shares of facebook. You decide to write uncovered call or naked calls which means that you do not own the underlying security. You are essentially shorting call options here. You short November 2015 call options. Eventually, when the options expire worthless, you get to keep $200. How did we arrive at $200? Each options contract represents 100 shares of facebook.
$2 x 100 = $200
But if the price of facebook increases to $120, you are obliged to sell shares at a price of $108 and buy it back to cover the position at $120. You have just lost $1200. How did we arrive at this figure? Each option contract is backed by 100 shares of the underlying security.
120 – 108 = 12
You have made a loss of $12 per share.
12 x 100 = 1200
You have made a loss of $1200 from buying and selling the shares.
But since you get to keep the premium, your net loss for the trade is:
1200 – 200 = 1000
In this scenario, you have lost quite a bit of money. This shows that for the writing of uncovered call options, you profit potential is capped while your loss can be unlimited.
If you are considering selling naked call options for a start, we’d advise you to rethink that. Instead, use a simple strategy like buying straight put options or straight call options for starters.
Example Of A Covered Call
You own a 100 shares of facebook currently. You know the fundamentals of the stock inside and out. In all probability, according to your calculations, the stock price of facebook will not hit $108. The current price of facebook stands at about $103.
You decide you are not going to just let the stock sit there without generating income. You decide to sell an out of the money November 2015 call options contract at an exercise price of $108. You sell it at $2 which allows you to collect $200 for the contract. How did we arrive at that number. Every options contract has 100 shares of the underlying security.
$2 x 100 = $200
And when your contract expires worthless by expiration date, you get to keep the $200.
If the price of facebook does move beyond the exercise price of $108 and the buyer of the option decides to exercise the right to buy, you would be forced to sell your 100 shares at $108. You are a call options seller. Therefore, you are obliged to sell 100 shares of facebook to your contracted buyer.
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