In a prior article, I discussed the risks and benefits of purchasing call options. In this article, I’ll explain why you might want to take the other side of the trade and sell call options.
Recall that a buyer of a call option has the right, but not the obligation to buy 100 shares of a particular stock (the underlying) at a specific price (the strike price) by a specific date (the expiration date). The seller of that same option is obligated to sell 100 shares of the underlying stock at the strike price if the buyer decides to exercise the option before the expiration date. If the seller already owns the underlying stock, the call option is referred to as a covered call. If the seller doesn’t own the stock, they’re selling a naked call. The buyer, in turn, pays the seller a certain amount for the right to buy the stock. The payment that the seller receives is called the option premium.
Naked Calls – Selling Calls on Stock That Isn’t Owned
The riskier of the two ways to sell a call is referred to as selling a naked call. This means that the option seller does not own the underlying stock and is taking the risk of having to purchase the underlying stock on the open market. Since the stock price can increase without limit, the potential losses are unlimited. On the other side, the potential gains are limited to the option premium. Figure 1 shows a representation of this.
This strategy can pay off if the stock remains flat or goes down, but can result in large losses if the stock price goes up. Although this is risky, there are ways for investors to hedge the risk, including by buying a call with the same expiration date but a different strike price, which is known as a call spread. Call spreads will be covered in a future article.
Covered Calls – Selling Calls on Stock Already Owned
When an investor sells a covered call, they’re selling a call on stock they already own. This is usually done in hopes of the stock remaining flat to slightly higher, which is where the call option seller stands to benefit the most. If the stock price is below the strike price at expiration, the seller keeps the premium and can repeat the process, collecting another premium. It is not unusual to collect 1-2% of the value of the stock per month, which makes for a nice annual return.
There are three risks to this strategy. If the stock price goes dramatically higher, the call seller will not benefit from the gains since the stock will be called away at the (now lower) strike price. Hence, the maximum gain is limited. A potentially larger risk is if the stock drops dramatically. The seller will ride the stock price down, and those losses could exceed any option premium collected. The third risk is specific to stocks paying large dividends. The call buyer might find it to their benefit to call away the stock immediately prior to the dividend payout, denying that dividend to the call seller.
The strategy of selling a covered call combines the profit/loss profile of owning the stock with the profit loss profile of a naked call. This is graphically represented in figure 2.
In certain cases, an investor can find it advantageous to sell call options. A seller of a naked call option is anticipating that the underlying stock will not increase. If it does, the option seller will have to purchase the stock at a much higher price and will face a large loss. A seller of a covered call option is anticipating that the underlying stock will remain relatively flat. If the stock increases, the covered call seller loses out on the gains while in the case of a decrease in the stock price, he may suffer a loss that wipes out the option premium.