Selling Call Options

Options are financial agreements between a buyer and a seller. An option is a contract that gives the owner the right, but not the obligation, to buy or sell an underlying asset on or before a specific future date. The owner can exercise the option or simply let it expire. Options are generally tied to stocks, futures markets, or commodities.

When an investor buys an option, they enter into a contract with a seller. The contract establishes a specific price, called the strike price, at which the contract may be exercised or acted on. A contract also comes with an expiration date. When an option expires, it is defunct and no longer has any value. The investor has the option to use the contract, sell the contract, or to let it expire.

Option Types

There are two basic types of options: put options and call options. Either can be bought or sold. In general, investors sell call options if they think the value of the underlying investment will fall in value. The contract locks in a specific price. Call options obligate the buyer to purchase the underlying asset if the option contract is exercised. The value of an option depends on whether or not it is in-the-money. For the seller, the option is in-the-money when the current value of the asset is below the price of the exercise price of the option.

The option gives the buyer a right and creates an obligation for the seller; consequently, the buyer pays an option premium to the seller. This is the price of the option. The seller starts the contract with a net credit after collecting the premium. If the option is not exercised, the seller keeps the money. If the option is exercised, the seller keeps the premium, but must sell the underlying asset.

Selling Call Options

Selling call options is a popular investment strategy. The seller bets that the stock price will fall, while the buyer believes it will rise. If the stock price falls, the seller has locked in a guaranteed sale at a higher price. Each seller also receives a premium from the buyer for offering to sell the shares at the exercise price of the option. Selling calls is usually a strategy used by investors who hold the underlying shares. More aggressive investors who do not own the shares and who speculate on stock prices also utilize this option strategy.

Selling call options is used primarily by three different investors: sellers who own the underlying stock, want to sell, and expect a falling market; sellers who own the underlying stock but don't necessarily want to sell the stock; and sellers who do not own the underlying stock, want to sell, and expect a falling market.

Selling call options while owning the underlying stock

Selling call options while owning the underlying shares is popular with investors whom want to sell out of their stock. They are betting that the shares will lose value in the market and can lock in a profit by selling a call option for the shares. The maximum profit for the seller depends on the underlying stock closing at or below the strike price of the option. The maximum profit is the premium plus any difference in the exercise price and the stock price. The maximum loss is unlimited, however: if the stock price rises, and the buyer exercises the option, then the seller must sell the stock, usually at a loss.

Investors can also sell a call option while owning the shares, but not sell out their position. This strategy generates profits from simply collecting the premium, paid by the buyer for the contract, without necessarily wanting the stock price to drop to maximize profits. The maximum profit is the premium plus any difference in strike and stock price. The maximum loss is unlimited, however: if the stock price rises, and the buyer exercises the option, then the seller must sell the stock, usually at a loss.

Selling call options without owning the underlying stock

Investors who don't own the underlying stock can also speculate on stock prices while selling call options. In this case, the seller bets that the stock price will drop. They lock in a contract with a buyer. If the stock price drops, they simple buy shares at the lower price and sell the buyer the contracted, higher priced shares, realizing a profit. The amount of profit for the seller depends on how far below the underlying stock closes below the strike price of the option. The potential for loss is unlimited, because as the stock price rises, the seller loses more and more ground on breaking even. In reality, the seller of a call option may not be able to fulfill the contract if the stock price rises too high. The seller is required to post a margin, based on a percentage of the outstanding shares and their price; if the seller cannot post the required margin, the contract can be closed early.

With call options, the buyer can end the contract three different ways: let the call expire, forfeiting the premium plus any commissions paid; exercise the call at any time during the contract when the price of the underlying security is above the strike price; sell the call to another trader before the contract's expiration.

Where to get more information
Web Sites

Chicago Board Options Exchange

http://www.cboe.com

Options Clearing Corporation

http://www.optionsclearing.com

OIC - Options Industry Council

http://www.888options.com

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