Selling a Call Option

Before proceeding with the mechanics of selling a call option, let's briefy review what we have discussed so far.

We've covered the process of buying a call option when we thought the price of a commodity would increase, and of buying a put option if we believed the price of a commodity would decrease. If our option became profitable, we would then liquidate it before the expiration date, by selling it back in the open market through the same futures exchange, in a process known as an offsetting transaction. In other words, when your ‘opening’ transaction is a buy, your ‘closing’ transaction will be a sell.

When we bought calls and puts, somebody else was selling them to us. Now, we’re going to be on the other side of the trade. We will be the sellers! And we will be selling a call option.

In other words, our ‘opening’ transaction is going to be a sell, and our ‘closing’ transaction will be a buy. Thus, this kind of selling is different than the one we’ve been involved with before, where we were selling back an option we had previously bought, in an offsetting transaction. Here, as the seller of the option, when we’re ready to close out our position, we’ll be buying back the option.

The reason you would sell a call option short, is because you’re expecting the price of the underlying commodity to either decline or remain unchanged.  

SELLING A CALL OPTION
As the price of the underlying commodity decreases,
the value of a call option decreases

    

In our previous section, if we thought the price of a commodity was going to decline, we’d buy a put option. So why not just buy a put option here? Because the benefits and risks of buying options are completely different than the benefits and risks of selling options. And you decide on which side of the fence you want to be in, based on these benefits and risks.

By selling short a futures call, you’re giving the buyer the right to buy a specified underlying futures contract from you at the stated strike price. Remember, you don’t really own what you’re selling. Instead, you’re creating a situation where there will be an offsetting purchase pending, to offset the position and bring everything back to balance. In other words, if the buyer of the option exercises his right to buy the specified underlying futures contract at the specified strike price, you will have to acquire a futures position at the current market price for that particular futures contract, and then sell it back to the buyer at the strike price of the option.

In effect, as an option seller, this would be your offsetting transaction if you lose with the option. The reason selling options carries unlimited risks, is that you have no control over how much the futures contract may increase.

When selling a call, the larger the gap between the increased market price and the strike price, the larger your losses.

 

On the other hand, if the buyer doesn’t exercise his right because the option doesn’t become profitable for him, then you don’t need to acquire a position in the futures market. You simply let the option expire.

Our break-even point calculation is a bit different than when you’re buying calls. Although you add the strike price to the premium, you must subtract your commission and transactions fees. Because here, you make money up to the break-even point (when buying calls, of course, you make money after the break-even point.)

 

CALL SELLING BREAK-EVEN POINT

Breakeven price   = Strike price + PremiumCommissions & Transactions  

 

Uncovered calls = you don’t own the underlying asset.

Covered calls = you own the underlying asset.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 The best way to grasp the concept will be to go over a  few examples. We’ll assume that we’re selling   uncovered call options (also known as "selling naked").

Therefore, the risk is greater than if we were selling covered options. You’ll find, as we go along, that time is on the seller’s side.

 

That’s right, the buyer’s greatest enemy -disappearing time value – is the seller’s greatest ally!
 

When you sell a call option, you receive up-front money from the buyer in the form of a premium. That is, the price the buyer’s paying for the option. This is the same premium we’ve been discussing in our previous sections, only this time -as the seller – the premium is paid to you. This money gets credited to your account. Your profit objective as an option seller is simple: hold onto this premium until the expiration of the option. And you’ll manage to do this, so long as the option doesn’t become profitable for the buyer and he exercises the option. So as you can see, your gain potential is limited simply to the premium amount the buyer paid you for the option.

 

Examples:

It’s the month of August. Soybeans are trading at $8.50 a bushel. You believe the price of soybeans will either decline or remain the same over the next few months. So you decide to sell a 925 November soybeans call.2 That’s .75 out of the money. The November call’s premium is 28.3 This translates to $1,400 (.28 x 5,000 bushels, or $50 per penny). You have commission and transaction fees that come to $100 or .02 per bushel ($100/5,000 = .02). So your break-even price is $9.51 ($9.25 + .28 – .02).


2 The common abbreviation for $9.25 a bushel.

3 The common abbreviation of 28 cents a bushel.

 

At this point, your brokerage account is credited with $1,400 minus commission and transaction costs:

CREDIT ACCOUNT  PREMIUM     $1,400
LESS TRANSACTION COST           – 100

BALANCE                                        $1,300

After some minor price fluctuations, the price of soybeans settles at $9.00, and the option expires. Since this is below the strike price of $9.25, the option expires worthless for the buyer and he cannot exercise it. Your net profit = $1,300.

CREDIT ACCOUNT  PREMIUM     $1,400
LESS TRANSACTION COST           – 100

NET PROFIT                                    $1,300
 

Suppose that instead of $9.00, the price of soybeans closes at $9.25 by expiration. Would the buyer exercise his right to buy soybeans from you? Not really. It would be senseless since he’s still out his $1,400 plus commissions and transaction fees. Remember, the call buyer’s break-even price is higher than the strike price of the option. Therefore, he’ll let the option expire worthless. You make $1,300.

To continue, let’s say that the price of soybeans closes at $9.30 a bushel. Would the buyer then want to exercise his right to buy soybeans from you at $9.25 a bushel? That’s 5 cents a bushel below the current market price. Of course he would. He’ll at least recover $250 from the premium and commissions he paid (.05 x 5000 bushels = $250). But you, as the seller, are still the winner. Your brokerage account would look like this:

CREDIT ACCOUNT  PREMIUM              $1,400
LESS TRANSACTION COST                    - 100

LESS OPTION INTRINSIC  VALUE          - 250  (.05 above strike price) 
NET PROFIT                                             $1,050


But, let’s suppose that the price of soybeans doesn’t close at $9.30, but rather keeps climbing beyond your break-even point, reaching $9.85. The buyer now exercises his right to buy soybeans from you at the strike price of $9.25. You’re obligated to ‘make good’ on the option, no matter how high it had gotten. This would force you – theoretically -to buy soybeans at the market price of $9.85 and deliver them to the buyer at the strike price of $9.25. As a practical matter though, you would simply offset  the option by buying it back and paying the exercise value difference. That is, the 60 cents difference between the market price of $9.85 and the strike price of $9.25.

Your account would look like this:

CREDIT ACCOUNT  PREMIUM              $1,400
LESS TRANSACTION COST                    – 100

LESS OPTION INTRINSIC  VALUE          -3,000  (.60 above strike price) 
NET  LOSS                                            ( $1,700)

 

But here’s one very important distinction: as the seller of the option,4 you can bail out at any time. In other words, you can cancel your open position any time before expiration and before exercise. And you would do this, of course, by buying back the same option.


4 The seller of an option is also referred to as the ‘writer’ of an option.

You’ll still make money if :

a) the price of the underlying commodity has declined.

b) the price of the underlying commodity remained the same.

c) the price of the underlying commodity increased, but is still below your break-even point.

d) the time value of the option declined.

 

For instance:  Continuing with our soybeans, suppose August and September goes by and the price remains at about $9.00. The option will expire in only one more month. This means that time value has shrunk enough that you may now have a choice. You can close out your position by buying back the option at a lower price (the price of the premium at this point is lower), or you can just wait for expiration, in which case you’ll keep the entire premium. The pros and cons, are that if you buy back the option now you’ll make less money, but you end your risk. You ensure your profits today. On the other hand, waiting for expiration keeps you exposed to risk until the end of the option, but provides you with greater financial reward.

As you can see, selling call options carries a lot of risk. Because of this risk, brokers will require that you maintain a margin in your brokerage account. This will vary from broker to broker, and serves as a protection in case exceptionally high losses are incurred.

One last point, while most calls aren’t commonly exercised early, once a call option reaches its strike price it could be exercised by the buyer at any time. Even if the call is still several months from expiration. If this happens, you’d be notified by your broker that your call has been exercised. The way it works, is that the Options Clearing Corporation (OCC), acts as a buyer to every seller and as a seller to every buyer. So when a buyer exercises an option, the order is randomly assigned to any seller.

Recapping what we’ve covered, there are two ways to make money as the seller of a call option:

  1. If the price of the underlying commodity remains below the striking price of the option (or to be more precise, below your break-even point.
     
  2. If the price of the underlying commodity remains stable and the option declines in time value, allowing you to buy it back at a lower premium.

     

Advantages and Disadvantages of Selling Call Options

The characteristics of selling a call option are completely opposite of those for buying a call option. Naturally, the advantages and disadvantages are opposing as well. Remember when we’ve mentioned before, that most option buyers lose money? Well, the opposite is true for most option sellers.

The reality is, that as a seller the odds are in your favor. Big advantage, no doubt!

ADVANTAGES :

  • Small capital commitment -The cost of selling a call option is substantially lower compared to the cost of buying a futures contract (or most any other asset.)
     
  • Higher probabilities of profit – the odds are automatically in your favor when you sell a call option. The price of the commodity can decline, remain the same, or even go up a little, and you still make money.
     

DISADVANTAGES:

  • Limited profit potential – Your potential profits are limited the premium paid to you for the option.
     
  • Unlimited risk – If the price of the commodity increases you’re obligated to make good on the option by acquiring an opposite futures position, regardless of how high the price becomes.

     

So why do people sell call options? Well, selling call options, in spite of its risks, can be highly profitable by providing a steady stream of income through the premiums you collect. The fact is, most call options don’t become profitable for the buyer. In fact, it is said that 90% of option buyers are losers. Either they move in the wrong direction, or they increase in price, but not enough to reach the striking price, and thus expire worthless. Also, as we’ll see later, you might sell a call option as part of a strategy, by combining this with some other technique that may allow you to cap your risk.
 

Next: Go to Selling a Put Option