Call Writing Explained

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The Basics of Covered Calls

Professional market players write covered calls to increase investment income, but individual investors can also benefit from this conservative but effective option strategy by taking the time to learn how it works and when to use it. In this regard, let’s look at the covered call and examine ways it can lower portfolio risk and improve investment returns.

What Is a Covered Call?

You are entitled to several rights as a stock or futures contract owner, including the right to sell the security at any time for the market price. Covered call writing sells this right to someone else in exchange for cash, meaning the buyer of the option gets the right to own your security on or before the expiration date at a predetermined price called the strike price.

A call option is a contract that gives the buyer the legal right (but not the obligation) to buy 100 shares of the underlying stock or one futures contract at the strike price any time on or before expiration. If the seller of the call option also owns the underlying security, the option is considered “covered” because he or she can deliver the instrument without purchasing it on the open market at possibly unfavorable pricing.

Covered Call

Profiting from Covered Calls

The buyer pays the seller of the call option a premium to obtain the right to buy shares or contracts at a predetermined future price. The premium is a cash fee paid on the day the option is sold and is the seller’s money to keep, regardless of whether the option is exercised or not.

When to Sell a Covered Call

When you sell a covered call, you get paid in exchange for giving up a portion of future upside. For example, let’s assume you buy XYZ stock for $50 per share, believing it will rise to $60 within one year. You’re also willing to sell at $55 within six months, giving up further upside while taking a short-term profit. In this scenario, selling a covered call on the position might be an attractive strategy.

The stock’s option chain indicates that selling a $55 six-month call option will cost the buyer a $4 per share premium. You could sell that option against your shares, which you purchased at $50 and hope to sell at $60 within a year. Writing this covered call creates an obligation to sell the shares at $55 within six months if the underlying price reaches that level. You get to keep the $4 in premium plus the $55 from the share sale, for the grand total of $59, or an 18% return over six months.

On the other hand, you’ll incur a $10 loss on the original position if the stock falls to $40. However, you get to keep the $4 premium from the sale of the call option, lowering the total loss from $10 to $6 per share.

Bullish Scenario: Shares rise to $60 and the option is exercised
January 1 Buy XYZ shares at $50
January 1 Sell XYZ call option for $4 – expires on June 30, exercisable at $55
June 30 Stock closes at $60 – option is exercised because it is above $55 and you receive $55 for your shares.
July 1 PROFIT: $5 capital gain + $4 premium collected from sale of the option = $9 per share or 18%
Bearish Scenario: Shares drop to $40 and the option is not exercised
January 1 Buy XYZ shares at $50
January 1 Sell XYZ call option for $4 – expires on June 30, exercisable at $55
June 30 Stock closes at $40 – option is not exercised and it expires worthless because stock is below strike price. (the option buyer has no incentive to pay $55/share when he or she can purchase the stock at $40)
July 1 LOSS: $10 share loss – $4 premium collected from sale of the option = $6 or -12%.

Advantages of Covered Calls

Selling covered call options can help offset downside risk or add to upside return, taking the cash premium in exchange for future upside beyond the strike price plus premium.during the contract period. In other words, if XYZ stock in the example closes above $59, the seller makes less money than if he or she simply held the stock. However, if the stock ends the six-month period below $59 per share, the seller makes more money or loses less money than if the options sale hadn’t taken place.

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Risks of Covered Calls

Call sellers have to hold onto underlying shares or contracts or they’ll be holding naked calls, which have theoretically unlimited loss potential if the underlying security rises. Therefore, sellers need to buy back options positions before expiration if they want to sell shares or contracts, increasing transaction costs while lowering net gains or increasing net losses.

The Bottom Line

Use covered calls to decrease the cost basis or to gain income from shares or futures contracts, adding a profit generator to stock or contract ownership.

Writing Call Options

Writing Call Options

Selling Call Options

Selling Covered/Naked Calls

Explanation of Writing a Call Option (Selling a Call Option):

If you understand that when you buy a GOOG $600 call option that you have the right to buy 100 shares of GOOG at $600, then you have probably asked yourself the question of “who exactly am I buying it from?” In order to have the right to buy the stock at the strike price, then somebody has had to take the other side of that transaction and agreed to give you the right to buy it from them. That person that takes the opposite side of the call option buyer is the “call option seller.” (Sometimes it is referred to as the “call option writer”.)

Just to be clear here, there are really two types of call option selling. If you bought a call option and the price has gone up you can always just sell the call on the open market. This type of transaction is called a “Sell to Close” transaction because you are selling a position that you currently have. If you do not currently own the call option, but rather you are creating a new option contract and selling someone the right to buy the stock from you, then this is called “Sell to Open”, “Writing an Option”, or sometimes just “Selling an Option.”

Definition of Writing a Call Option (Selling a Call Option):

Writing or Selling a Call Option is when you give the buyer of the call option the right to buy a stock from you at a certain price by a certain date. In other words, the seller (also known as the writer) of the call option can be forced to sell a stock at the strike price. The seller of the call receives the premium that the buyer of the call option pays.

If the seller of the call owns the underlying stock, then it is called “writing a covered call.” If the seller of the call does NOT own the underlying stock, then it is called “writing a naked call.” Obviously, in this instance it is “naked” because the seller does not own the underlying stock. The best way to understand the writing of a call is to read the following example.

Example of Writing / Selling a Call Option:

It’s January 1st and Mr. Pessimist owns 100 shares of GOOG stock that he bought 5 years ago at $100. The stock is now at $600 but Mr. Pessimist thinks that the price of GOOG is going to stay the same or drop in the next month, but he wants to continue to own the stock for the long term. At the same time, Mr. Bull just read an article on GOOG and thinks GOOG is going to go up $20 in the next few weeks because GOOG is about to have a press release saying they expect their China traffic to be very strong for the year.

Mr. Pessimist gets a quote on the January $610 call on GOOG and sees the price at bid $5.00 and ask $5.10. He places an order to SELL 1 GOOG January $610 call as a market order. Mr. Bull also places a market order to BUY the very same GOOG option contract. Mr. Pessimist’s order immediately gets filled at $5.00 so he receives $500 (remember each option contract covers 100 shares but is priced on a per share basis) in his account for selling the call option. Mr. Bull immediately gets filled at $5.10 and pays $510 for the GOOG January $610 call. The market maker gets the $10 spread.

Once the trade is made, Mr. Pessimist hopes that GOOG stays below $610 until the third Friday in January. Meanwhile, Mr. Bull is hoping that GOOG closes well above $610 by the third Friday in January. If GOOG closes at $610 or below then the call option will expire worthless and Mr. Pessimist profits the $500 he received for writing / selling the call; and Mr. Bull loses his $510. If GOOG closes at $620, then Mr. Bull would exercise the call option and buy the 100 shares of GOOG from Mr. Pessimist at $610. Mr. Pessimist has now received $500 for writing the call option, but he has also lost $1000 because he had to sell a stock that was worth $620 for $610. Mr. Bull would be happy in that he spent $510, but he made $1000 on the stock because he ended up paying $610 for a stock that was worth $620.

I noted earlier that 35% of option buyers lose money and that 65% of option sellers make money. There is a very simple explanation for this fact. Since stock prices can move in 3 directions (up/down/sideways) it follows reason that only 1/3 of the time will the stock move in the direction that the buyer of the stock or the buyer of the put wants. Therefore, 2/3 of the time the seller of the option is the one making the money!

To think of this another way, think of option trading as the turtle and the hare story.

Option buyers are the rabbits that are generally looking for a quick move in stock prices, and the option sellers/writers are the turtles that are looking to make a few dollars each day.

In the YHOO examples above we said that if YHOO is at $27 a share and the October $30 call is at $0.25 then not many option traders expect YHOO to climb above $30 a share between now and the 3 rd Friday in October. If today was October 1 st and you owned 100 shares of YHOO, would you like to receive $25 to give someone the right to call the stock away from you at $30? Maybe, maybe not.

But if that October $30 call was currently trading at $2 and you could get $200 for giving someone the right to call you stock away at $30, wouldn’t you take that? Isn’t it very unlikely that with only a few weeks left to expiration that YHOO would climb $3 and your YHOO stocks would be called away? In effect, you would be selling your shares for $32 (the $30 strike price plus the $2 option price).

Option sellers write covered calls as a way to add income to their trading accounts by receiving these little premiums each month, hoping that the stock doesn’t move higher than the strike price before expiration. If the October calls expire worthless on the 3 rd Friday in October, then the immediately turn around and sell/write the November calls.

When you own the underlying stock and write the call it is called writing a covered call. This is considered a relative safe trading strategy. If you do not own the underlying stock, then it is called writing a naked call. This is considered a very risky strategy so don’t try this at home!

Important Tip! The reason that option sellers/writers usually win on their trades is they have one very important factor on their side that the option buyer has working against them—TIME.

If today is October 1 st and YHOO is at $27 and we write the YHOO $30 call to receive $2.00, we have 21 days to hope that YHOO stays below $30. Each day that goes by and YHOO stays below $30, it become less and less likely that YHOO will pop over $30 so the option price starts decreasing. On October 10 th , if YHOO is still at $27 then the October $30 call would probably be trading at $1.10 or so. This is called the “time decay” of options in that each day that goes by the odds of a price movement become less and less.

This is the turtle winning the race!

Here are the top 10 option concepts you should understand before making your first real trade:

Call Writing

Call writing is a branch of options trading strategy involving the selling of call options to earn premiums. One can either write a covered call or a naked call. Furthermor, using a combination of covered calls and naked calls, one can also implement the ratio call write.

Put Writing

Besides the selling of calls, there are also strategies for selling put options. See put writing.

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