Understanding how to sell call options

• When selling a call option, you're selling the right, but not the obligation, to someone else to purchase an underlying security at a set price before a certain date.
• The seller gets a premium for agreeing to deliver the underlying security for a pre-set price before a set date if the buyer demands it.
• If the price of the underlying security stays the same or goes down, the seller keeps the premium as profit. If it goes up, the seller loses all or part of the premium and, in some cases, much more.

When you sell a call option, you're selling the right, but not the obligation, to someone else to purchase the underlying security (stock) at a set price before a certain date (expiration). You charge a fee (premium) of a set amount per share.

If the price of the security stays the same or drops until expiration, the option expires worthless and you keep all of the premium as your profit. If the price goes up, the buyer may exercise their option and you will have to sell them the security at the agreed upon price. In this case, your premium is reduced by the difference between the price you pay for the security and the price you're forced to sell it to the buyer for. In many cases, you'll lose money.

Understanding options

In the stock market, an option is a contract between two people, one the seller, the other the buyer. When you are the buyer, you have the right, but not the obligation, to buy or sell a security for a certain price within a certain time. When you are the seller, you have the obligation to buy or sell the security for a certain price within a certain time.

The two main types of options are calls and puts. Either can be bought or sold. The buyer of a call option is bullish and believes the underlying stock will rise in price before the option expires. The seller of a call option is bearish and believes the price will stay the same or fall.

The buyer of a put option expects the underlying stock to fall below the strike price before expiry while the seller expects the price to stay the same or rise.

Terms related to options include:

• Option contract. The agreement between buyer and seller.
• Underlying asset. The specific stock and how many shares (usually 100).
• Calls and puts. A call is an option to buy; a put is an option to sell.
• Strike price. The set price at which an options contract can be bought or sold when it is exercised.
• Expiration date (expiry). The date the contract is no longer valid.
• Writer. The person who sells an option is called the seller or writer.
• Holder. The person who buys an option is called the buyer or holder.
• In the money (ITM). The option is considered profitable.
• At the money (ATM). The option is at "break-even" status.
• Out of the money (OTM). The option is considered unprofitable.

Quick tip: Another type of option, called an employee stock option, gives employees the right, but not the obligation to purchase shares of company stock at a fixed price during a set time period. This is a type of call option.

Selling call options

As the seller of a call option, you believe the underlying stock will stay the same or fall in value before expiry. You sell a call option consisting of the right to purchase 100 shares of a stock before the expiration date of the contract for a set price. This part is the same no matter which type of call option you choose to sell. The reason for selling a call option is also the same: To profit by keeping the premium you charge for the contract.

Quick tip: It's important to remember that when you sell a call option, your potential upside (profit) can be limited to the premium you receive and your downside can be unlimited.

Here are the various types of call options to know about:

1. Covered call/Buy-write call. This refers to selling a call option on stock you own. "Covered call writing is a very conservative investment strategy and a method to generate additional income," says Robert R. Johnson, professor of finance at Creighton University. "Essentially, a covered call writer is selling some upside potential in exchange for additional current income. This is particularly useful for investors who are in retirement and are seeking additional income." You could already own the stock or you could buy it at the time you write (sell) the option.

• If the price of the underlying stock stays the same (ATM) or goes down (OTM) by expiration, you keep the entire premium and the contract expires worthless.
• If the price goes up (ITM), you have to sell the stock for the strike price. Your profit (or loss) will consist of the premium plus the difference between the cost of the stock when you bought it and the strike price.
• The main advantage of a covered call is that it gives you the ability to limit your losses in the event the underlying stock doesn't move as you anticipate.

Quick tip. It's critical that you set the strike price above the price you pay (or paid) for the underlying stock.

1. Naked call. In this scenario, you don't own the underlying stock to begin with.

• If the stock is at or OTM at expiration, you get to keep the premium and the contract expires worthless.
• If the underlying stock is ITM, you have to buy the stock at the higher price and sell it to the buyer for the lower strike price. Your profit (or loss) will consist of the premium plus the strike price minus the cost of buying the stock at the new higher price. These losses could be unlimited.
• The main advantage of a naked call is that you do not have to invest any money at all unless the underlying stock doesn't move as you anticipate.

1. Sell to close. This is when you, as the original buyer of a call option, decide to sell your option to take advantage of a stock that is ITM. This is something you may want to do instead of exercising your option with the original seller.

• You sell your option to a new buyer and pocket the premium you receive as profit. Your position is closed.
• The original seller now has a new buyer and may have to sell the stock to them at the new strike price if the new buyer exercises their option before expiration.
• The main advantage of sell to close is your ability as a buyer to become a seller before expiry and avoid commissions and other fees.

Quick tip: In sell to close, the original buyer becomes a seller. The original seller is now obligated to sell to the new buyer, upon demand.

What does it mean to sell a call option?

Call option sellers believe the underlying security will end up ATM or OTM and they'll be able to keep the entire premium as profit when the option expires worthless. Your risk varies depending on your position with regard to the underlying stock as noted above.

If you own the underlying stock (or buy it when you write the call) and suspect the price will decline, you can sell a covered call option to collect the premium and recover at least some of your anticipated loss or even turn a profit if you set the strike price correctly.

This type of option selling is less risky than selling a naked call option since you are not at the mercy of a rising stock price in order to fulfill your obligation to sell the underlying to the buyer.

"Especially when trading shorter duration options, have a trade plan," advises Nick Griebenow, Portfolio Manager for Shelton Capital Management's Option Overlay Strategies. "This isn't like buying a stock and holding it forever – this trade will come to a close by expiration at the latest so have your exit points, both at a profit and a loss, in mind before you enter the position."

Quick tip. The alternative to selling a call option is to buy one. Buying a call option would make sense if you believe the underlying stock will rise above the strike price. Your risk is limited to the premium.

Examples of selling a call option

1. Covered call/Buy-write call example: You own (or buy) 100 shares of ABC stock, currently valued at $10 per share. You want to generate some income from those shares and don't think they will rise above their current price for the next month.

You sell a covered call option with a strike price of $12, set to expire one month from now, for a premium of $1 per share ($100). A buyer pays you $100 for the right (but not the obligation) to buy your ABC stock for $12 a share one month from now. As you predicted, ABC never rises above $12 per share. After one month the option expires worthless and you keep the $100 as profit.

Alternatively, suppose your shares of ABC end up climbing to $15 per share within the month. The buyer exercises their option and buys your 100 shares for $12 each and immediately sells them for $15 ($1,500 total) walking away with a $200 profit ($300 - $100 premium). Your gain is the $100 premium plus the difference between the $10 you paid for the stock and the $12 you sold it for. ($200). Your total profit of $300, $100 more than that of the buyer.

1. Naked call example: You don't own the $10 shares and don't want to buy them. As in the scenario above, a buyer pays you a $100 premium for a one month contract on 100 shares of ABC with an expiration date in one month and a strike price of $12.

As before the price never gets above $12. The contract expires worthless and you walk away with the $100 and no further obligation.

But what if, as before, the shoots up to $15 and the buyer exercises their option, you have to buy 100 shares at $15 and sell them to the buyer for $12? You still have the $100 premium but lose $300 on the stock transaction ($1,500 - $1,200). That's a net loss of ($200).

1. Sell to close example: Recall that in this scenario you are the buyer of a call option on 100 shares of ABC with a strike price of $12, a $1 a share premium, and expiration in one month. You paid a $100 premium for this contract.

You notice that the stock price remains at $12 with two weeks to go. You sell the contract for $0.50 ($50), get back half of the premium you paid and mitigate your losses.

Alternatively, the stock price has jumped to $15 with two weeks to go. You could exercise your option, buy the stock, and pick up a $200 profit ($300 - $100). Since you would also lose some money to commissions and other costs, plus you have to come up with $1,200 to buy the stock from the seller, you decide to sell the option. You sell your (potentially profitable) option to a new buyer for $2/share ($200), and walk away. Your profit is $100 ($200 - $100). Not the $300 you could have received but also no risk the stock price will drop and, again, no commissions or other costs.

All calculations in these examples assume no transaction fees.

Pros and cons of selling call options

As with most types of investing, selling call options comes with both upside and downside. Pros include earning additional (premium) income on stock you already have or even stock you don't own. This action is repeatable, meaning you could sell a one month covered call 12 times in a year. Finally the premium you receive is paid upfront and is yours to keep no matter what happens.

On the downside, premiums are limited, which means profit potential is limited. By not being able to sell the underlying stock without buying back the contract, you may lose out on a huge positive swing in the underlying stock.Worst of all, depending on the type of call option you sell, your losses could be unlimited.

"Investors are often tempted to trade naked options because it appears attractive to collect the options premium," says Alexander Voigt, founder and CEO at daytradingz.com. "However, selling options without limiting the risk by hedging the options trade involves unlimited risk. Unforeseen overnight price gaps caused by news catalysts like earnings announcements involve the highest risk."

The financial takeaway

Selling call options offers both advantages and disadvantages compared to buying and selling securities. Options provide a way to supplement investing income with reasonable risk. This is especially true if you already own the stock but also possible if you are careful when selling naked options.

With all types of investing, it's important to compare risk vs. reward, never exceed your risk tolerance or, for that matter, your financial limits. Learn about and be prepared to utilize other option strategies including buying calls, selling buying puts, and combinations of all of the above. And make sure you consult with a trusted investment advisor who is knowledgeable about options before jumping in.

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