Selling Call Options – What You Need to Know

July 15, 2017 0
what you need to know about selling call options

Selling call options has always been a popular options trading strategy among qualified traders due to the lack of downside risk associated with the strategy. Selling calls is also commonly referred to as writing calls.

Essentially, there are two methods of selling calls: naked and covered.

Unlike selling put options, selling call options can never be a cash-secured strategy, because any underlying asset can theoretically trade to infinity. Think of it this way, selling naked call options is equivalent to shorting a stock; the maximum loss is undefined.

For example, even if a trader had $900 trillion dollars in their account, and wanted to sell just 1 $55 call on stock XYZ trading at $50, the position would STILL not be covered. Although it’s highly implausible, XYZ could theoretically trade to infinity. It’s a scary thought for call sellers.

As discussed in what are stock options, a call option is a financial contract that gives the buyer the right, but not the obligation, to buy the underlying security (like a stock, futures contract, currency, etc.) at a specific price at any time until the contract expires.

Subsequently, this means the seller of a call option is obligated to sell the underly security at a specific price at any time until the contract expires. This mandatory obligation to sell the underlying asset is a key principle of selling call options vs buying call options. Call sellers need to be aware of this.

 

Two Forms of Selling Calls

(click on each graph for detailed examples and explanations)

Graph displaying the potential profit/loss of the covered call option strategy at expiration.

Graph displaying the potential profit/loss of the short call option strategy at expiration.


Short Calls (Naked): Selling naked calls implies using leverage in a margin account to sell call options on an underlying security where it is impossible to cover the potential forced short sale of the underlying at the short call strike price.

Covered-Calls: Selling a covered call means the call seller owns the appropriate amount of shares (or futures contracts) of the underlying asset to cover the potential forced sale of the underlying asset at the short call strike price.

 

Why Sell Call Options?

There are a couple of reasons that traders like to sell call options as opposed to put options. For starters, if the market completely crashes, or if a financial crisis ensues, selling call options is not going to cost you your house. This is not to say that selling naked puts runs the risk of owing your broker more than the value of your account, but the risk is technically there for a large put position.

Stocks and index futures seldom crash up. This is especially the case for index futures. Most of the capitulation and fear is priced in to the downside, because that’s where long investors are going to be forced out of their positions if the bottom truly fell out.

Naturally, despite the theoretical unlimited loss, a lot of traders are more comfortable selling call options because there is no downside tail-risk.

When short call option positions are managed and sized properly, it is a highly effective strategy for generating income and reducing cost-basis.

 

Benefits of Selling Call Options Naked

The benefit of selling call options naked, as opposed to covered, (because covered is the only other alternative) is that you won’t be long the underlying asset. See the full explanation of short call options.

Here’s why this is important. Selling calls is primarily a bearish strategy, even though the strategy will work with a neutral or minimally declining underlying asset. Because it’s a bearish strategy, if you are simultaneously long the underlying, a true collapse or crash (which would be beneficial to the short calls) would not be beneficial to being long the underlying.

This is where naked calls shine. Not only can you sell more contracts, which is great because owning 100 shares of stock for every 1 contract is capital intensive for high-priced stocks, but you also won’t be left with a losing long position if prices decline.

A lot of traders turn to naked calls after trying the covered call strategy and noticing that the short call expires worthless, but the long stock position (or long futures, currency, etc.) ends up costing them money.

 

Benefits of Selling Call Options Covered

Simply put, the benefit of selling covered calls is defined risk. The upside risk for a covered call is nonexistent, since the position is covered. See the full explanation of the covered call option strategy.

 

The Risk of Selling Calls

The risk with all options selling strategies is real. For selling put options, if the underlying asset goes to zero, the put seller will rue the day he decided to sell puts – seriously. With that said, selling OTM puts is highly effective, because often the large downward price movements necessary for the puts to expire ITM just don’t happen.

If the put is covered, there’s actually no downside risk. Selling a covered put is essentially a hedge to a short position. The risk is being short the underlying.

On the other hand, for naked and cash-secured puts, there is a huge downside risk. If the underlying asset collapses, or if volatility surges, naked and cash-secured puts are going to take on water.

 

Super Important Info On Selling Call Options

Although stocks, futures, and indices rarely go to zero, it does happen. Think, ENE, ZQK. And because it can potentially happen, puts commonly trade more expensive than calls. This is precisely what put options sellers like to take advantage of.

The seller of a put aims to capture the premium and is willing to risk a decline in the underlying asset.

The buyer of a put is willing to risk losing the premium due to upward moves in the underlying asset as well as theta decay.