Now that you’ve read my first guide on the basics of stock options and buying calls, it’s time to learn how to sell call options.
Selling calls is a powerful strategy that lets you generate income with minimal risk. This is also known as writing call options, so I’ll use the two terms interchangeably. I’ll also walk you through examples of how to sell a call.
Note: While this guide is for the absolute beginner, it also assumes that you are reading the articles in order. So, if you haven’t yet read What are Options? A Beginner’s Guide, please do that first.
Let’s dive in.
Table of Contents
- Take What You Know So Far, and Do the Opposite
- To sell call options, think of everything in reverse
- The Benefits of Selling Call Options
- Selling Call Options Reduces Risk and Generates Income
- Selling covered calls is a low risk, high-probability trade
- Take the Best of Both Strategies
Take What You Know So Far, and Do the Opposite
Selling calls is simply the opposite of buying calls. If you buy a call option, you expect the underlying stock price to increase. If you sell a call, you want it to decrease.
For example, let’s pretend that XYZ stock is selling for $150. Now let’s say that you expect the price to increase, so you buy an in-the-money (ITM) call option with a strike price of $145 that expires in 30 days. This means that you have the option, but not the obligation, to buy XYZ for $145 regardless of its market price.
If your prediction is correct, and XYZ sells for say, $160, within the next 30 days, you could still buy it for $145. You could then immediately sell it for the market price of $160. As I wrote in the first guide, however, it is far more likely that you will simply close out your call option rather than buying the underlying shares. Doing so would net you a greater profit because of the option’s extrinsic/time value.
To sell call options, think of everything in reverse.
Let’s use the same scenario. XYZ is selling for $150, but this time, you believe the price will decrease. So, you take the other side of the arrangement described above. You are now the seller. (You don’t even need to own the shares. If you have a margin account, your broker will allow you to sell something that you don’t own.)
Let’s say that you decide to sell an out-of-the-money (OTM) call for $155. As the seller, you are obligated to sell shares of XYZ for that price. This is a crucial difference between option buyers who have the option but not the obligation to buy shares.
Now imagine that your prediction is correct, and XYZ drops to $140. The call option contract that you sold means that you can sell it for $155 even though the market price is well below that.
What about the person on the other side of your contract—the buyer. I said earlier that that person has the right—but not the obligation—to purchase shares at the strike price. Why would anyone want to purchase shares from you at $155 when she could buy those exact same shares on the open market for $140?
The answer: she wouldn’t!
She would simply let the call option that she bought expire worthless. It makes zero sense for her to exercise her option and pay more for the shares.
The Benefits of Selling Call Options
Why would you want to sell call options?
Because by selling an option, you collect a premium.
Remember how option contracts are priced:
Intrinsic Value + Extrinsic Value = Option Price/Premium
If you are the buyer, you have to pay a premium. But as the seller, you collect the premium.
Going back to our example, let’s imagine that selling an OTM call option of XYZ with a strike price of $155 would net you a premium of $4.35. Remember, however, that one option contract represents 100 shares. Therefore, you would collect $435 immediately ($4.35 per share x 100 shares = $435). That $435 premium is yours to keep no matter what!
But what happens if you’re wrong and XYZ ends up selling for $160, $5 more than your strike price of $155?
In that case, the seller will exercise the contract, and you will be obligated to sell shares for $155. If you don’t own those shares, this is an expensive problem. You would have to buy the shares at the open market price of $160 only to be forced to sell them for $155. You’d take a loss of $5 on each share…well, sort of.
I say “sort of” because we have to account for the premium that you collected, which amounted to $4.35 per share. When you factor this into the equation, your cost basis for the share purchase is $155.65.
$160 market price minus the $4.35 premium that you collected = $155.65
Since you are still obligated to sell your shares for $155, you’ll still lose money, but not nearly as much. You’ll be out $35 (100 shares x $0.35), which is the difference between your cost basis of $155.65 and what you sell the shares for ($155).
Notice that when you sell a call option, your max profit is the premium you receive, but your max loss is infinite. This is because stocks can theoretically increase an infinite amount. That means that there is no limit to how much you would have to pay to buy those shares before turning around and selling them.
Why then would anyone want to sell call options?
Because despite the theoretical infinite loss, selling options is actually a conservative strategy.
Selling Call Options Reduces Risk and Generates Steady Income
First, just like when you buy an option, you can close your trade at any time. For example, if you sell a call, but the stock starts to rise, you can close your trade and take a small loss. You don’t have to wait until expiry.
Second, selling a call option is a great strategy for investors who want to generate regular income. This is especially true if you sell covered calls. (Selling calls is not, however, a good strategy for short-term traders seeking larger gains).
A covered call is when you write an option against shares you already own. For example, imagine that you own 100 shares of XYZ. You can sell/write a call option, which means that you agree to sell those shares at a pre-defined amount. In the example we’ve been using, that amount is $155.
In this scenario, if XYZ is selling for less than $155 at expiry, the option is worthless and you’ll keep 100% of the premium. One of the best parts of this strategy is that the underlying share price can even increase slightly, and you’ll still make money! This all comes back to the premium you received.
In the example I described in the previous section, you collected $4.35 per share. This means that as long as XYZ closes below $159.35, you’ll make a profit. ($155 strike price + $4.35 premium collected).
Therefore, there are multiple ways for you to profit by writing calls:
- The underlying stock price decreases.
- The underlying price stays the same.
- The underlying price increases slightly.
Selling covered calls is a low risk, high-probability trade.
Having so many ways to profit gives you a high statistical likelihood of booking a winning trade. You only lose if the underlying stock increases more than the amount of premium that you collected.
A covered call also carries minimal risk because you already own the shares. Therefore, unlike the first scenario I described above, you do not have to go out and buy the shares at the market price. (That is called a naked call).
If the option finishes ITM, your shares will be called away—hence the term “call” option. It may be frustrating that you are forced to sell your shares below the market price, but at least you don’t have to buy them for that amount.
That is why it’s important to only sell covered calls on a stock that you want to sell. If you plan on keeping those shares for the long haul, don’t write covered calls against them.
Another way that investors generate income with covered calls is by continuing to write options against those same shares. If the option contract expires worthless, you keep your shares. You can then write a call option against them again. You can continue this process until your shares are called away or you no longer want to sell them.
All of the above factors make selling covered calls a conservative, safe, income-generating strategy.
Take the Best of Both Strategies
That’s it for the second guide in my series on how to multiply your profits with stock options. You now know the basics of options, how to significantly boost your profit potential by buying calls, and how to generate income by selling calls.
In the next guide, I’ll review my favorite strategy: vertical spread options. You’ll learn how to combine the profit potential of buying calls with the limited risk of selling them.
Just like in the first two guides, I’ll explain the strategy and provide examples. For now, just know that it involves buying a call option and selling one at the same time. I’ll also show you how to set this up in a brokerage platform.
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