Selling Calls, also known as writing calls can generate a profit when shares are decreasing in value. The writer hopes the market price will stay below the strike price plus premium cost, or “out the money”. This is a bearish move. In the money calls are worth more than out the money calls to buyers, but as a writer your “out the money calls” have a far lower chance of being exercised.
Call value increases the further into the money they are. You earn less profit for selling calls that are out the money, but won’t incur additional losses due to exercised options. Options decrease in price the further out the money they are; to offset the higher risk price won’t reach “in the money” status for the call buyer. If they do reach “in the money” status their premium value will be higher… alongside the risk of additional losses.
Calls are more valuable if the exercise price is lower. A low exercise price is more likely to be “in the money” than a high exercise price. Higher exercise prices are less valuable since they’re less likely to reach “in the money”. As compensation for this risk, premium prices are higher if the exercise price is lower. The premium paid decreases as the exercise price increases.
If you’re selling calls, you can sell calls that are already “in the money” to collect increased premiums or “out the money” calls to reduce risk of exercise by the holder. Either way, the premium is your maximum potential gain. Options are normally only exercised if the holder will realize a profit. If they don’t, the writer collects the premium. The formula for profit is below. Note: the formula section within parenthesis only occurs if the option is exercised and will typically result in a loss.
(Where market price is underlying price at any present point for an American style option, underlying price at expiration date for a European style option, or average underlying price before expiration for an Asian style option)
You can sell calls that are naked, or covered. Naked calls are written by writers who don’t own the underlying investment. Covered calls are written by those who own the underlying asset. Risk changes substantially between these differing positions. A covered call can simply deliver it to the option holder for the strike price. If a naked call is exercised the writer must purchase the underlying asset in the market, and then deliver it for the strike price.
The risk difference is due to the price which the underlying asset was acquired. For example: Someone selling calls buys the underlying asset for $30. They write their covered call for a $2 premium and a strike price of $35. The underlying’s market price rises to $40 and the option is exercised, they sell the asset for $35. They gain $5 from the rise from $30 to the strike price of $35. They lose the unrealized $5 they would have earned if they sold the asset at $40. They keep the $2 premium earned, for a total gain of $7 before commissions or fees.
The situation is much worse for the naked call writer after exercise. They write their covered call for a $2 premium and a strike price of $35. The underlying’s market price rises from the same $30 to $40 and the option is exercised. They must buy the asset for $40 in the market and deliver it to the call holder. They keep their $2 premium for a total loss of $38. This is why a naked call option should be rapidly sold if the option is approaching “in the money” status.
You shouldn’t write covered calls on underlying assets you would like to keep in your portfolio. There is always a chance that you’ll lose these assets to option holders’ exercises. If you do, you should cancel out the option as it moves closer to “in the money” status. If you change your mind you can always simply write a replica of the call you canceled out later on.
This changes if you’re writing a covered call on an asset you’re willing to sell. In the example, an early sale price is secured in advance by selling a call at a value that delivers comfortable profit plus the premium. If the stock price is less than the exercise price, your covered call won’t be exercised and you profit from the premium earned.
If you want diverse results, write multiple covered calls with differing exercise points at various prices above the current market price of the underlying owned. Assign the written calls various expiration dates. This protects you against volatility, since some will be called and others won’t. Be careful about using American styled options with this, since they can be exercised any date before expiration. You could theoretically find many of them triggered on the same day. It’s better to use European options with this strategy, since they can only be triggered on the date of expiration.
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