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Understanding Stock Options Part Three

By Edited Feb 17, 2016 0 0

Part one of this series gave some general definitions and in part two of this series we looked at how the purchase of a call option works.  To review, the purchase of a call option gives you the right to purchase a stock at the specified strike price.  When purchasing a call option your risk is limited to the premium you pay.  Now let’s take a look at the opposite side of the transaction: selling a call option.

Selling a Call Option

If the purchaser of a call option has the right to purchase a stock then the opposite is true for the seller of a call option.  The seller has the obligation to sell the stock to the purchaser at the specified strike price and at the specified date.

If the owner of shares in XYZ sells a call option, then they are giving the purchaser the right to purchase their shares and they have an obligation to do so.

Examples of How a Call Option Sale Works

You own 100 shares of XYZ Company and the stock is trading at $10.  You decide to sell a call option that gives the buyer the right to buy your shares at $11.  This means that if the stock is trading above $11 at the expiration date then you have the obligation to sell your stock to the buyer for $11 even if it is trading at $15 should he choose to exercise their right.

However if the stock is still trading at $10, while you still have the obligation to sell your stock for $11, the buyer will not exercise his right and you get to keep the premium you received when you sold the call option.

One way you can kind of look at it is the premium you receive is extra money you get for owning the stock as long as it does not hit the strike price.

Reasons for Selling a Call Option

The main reason someone will sell a call option is to create an extra “yield” on their stock holdings.  It is a little extra income you get for just owning the stock and is a nice way to earn a little extra return on your stock holdings.  However the downside risk is that the stock goes up a lot and you have to sell it at the lower strike price and don’t get to participate in the gains the stock has made.

The other reason for selling a call option is for pure speculation.  Someone may think the stock is “dead money” and not going anywhere so they sell a call option with the hopes of just getting to keep the premium and make free money.  The big risk here is that if the stock goes up a lot then the seller of the call option will have to purchase the stock at the high price and sell it at the lower strike price.

This practice is sometimes referred to as going “naked” because you are under the obligation to sell shares that you do not own.  I would not recommend the average investor undergo this practice.



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