A call option is a financial contract established between a buyer and a seller that provides the buyer with the right to purchase the security option at a specific price prior to the expiration of the contract. While the buyer does not have an obligation to buy the option, the seller is obligated to sell it at the strike price at any point prior to the expiration of the contract.
Due to its quick reward and low risk, selling a call option has become a common options trading technique throughout the trading community.
If you’re looking to make money selling call options, it is important you understand the two methods of selling calls as well as the benefits and risks that the sale involves.
Basics of Selling a Call Option
When you sell a call option, you are giving the buyer the right to purchase a stock at a specific price, known as the strike price, with a set expiration date. This means that regardless of the direction the market goes, if the buyer chooses to act, you will be required to sell the stock at the strike price established.
A few key principles to take note of when selling a call option include the following:
- There are two ways to sell a call option: covered and naked.
- Call options cannot be a cash-secured method.
- In order to make a profit selling call options, the option must expire worthless.
It is important not to confuse call options with put options. A cash-secured put option allows the seller to write the put and set aside the cash needed to buy the share at the same time. As noted above, call options do not allow for this additional security.
Ways to Sell a Call Option
There are two types of call options you can sell:
- Covered call option
- Naked, or short, call option
When the seller owns the stock that the call option is based on, the call option is considered covered. This form of call option is viewed as a lower risk call because the seller has already purchased the stock at a price below the given strike price. This premium means that the seller is protected, or covered, against a loss even if the buyer chooses to purchase the call option. Although the seller will not actually lose any money, it is possible that he or she will miss out on a greater profit.
When the seller sells a call option in which he or she does not own the stock or underlying security, it is considered a naked, or short, option. This type of call option sale is a higher risk endeavor because the stock price does not have a limit and the seller is not protected against a loss through ownership of the share.
If the buyer decides to purchase the call option, the seller has an obligation to purchase the stock at the market price. If this market price is greater than the strike price, then the difference between the two is considered a loss to the seller. To negate this loss, many sellers of naked call options apply a significant fee.
Reasons to Sell a Call Option
There are a few reasons that individuals prefer to sell call options rather than other forms of security trading such as put options. Some of these reasons include the following facts:
- The risk of loss is more controlled.
- Shares and futures rarely crash up.
Any form of security trading is accompanied with some risk; however, in the event that selling a call option turns into a loss, the seller does not need to worry about going bankrupt or losing any larger assets. Additionally, selling call options removes the threat of being forced out of a market position in a case of the market crashing. This is because shares and futures very rarely crash up. Traders more often fear a downward crash. Therefore, although there is a technical risk of unlimited loss, many traders are confident in selling call options because of the absence of a downside tail-risk.
To summarize, selling call options can be controlled to the point that the seller can manage and size the asset in a way that results in a regular income and a low risk of loss. This makes selling a call option a popular choice for traders.
Risks and Benefits of Selling Call Options
While selling naked call options comes with higher risks, they also have the lure of a lower upfront cost. This is because the seller does not have to own the underlying assets, therefore, the only cost to them is what is needed to sell the call.
The term “naked” gives a very visual description of the risk imposed by selling naked calls. The seller is in a vulnerable position with little resources to protect him or her. The risk of selling a naked call is essentially unlimited because the price of shares could technically increase to infinity or decrease to zero.
Suppose the seller sells the naked call and the share price drops significantly. Regardless of the drop, the seller must purchase the stock at the strike price. Now consider a situation in which the stock jumps significantly above the strike price. The buyer has a right to the stock which means that the seller has to purchase the share at the market price and then sell it to the buyer at the specified strike price. This is where the risk of unlimited loss comes into the picture.
Selling a covered call option provides the seller with a more secure strategy. No matter which direction the market goes, the seller will receive money from the sale of a covered call. Benefits of selling a covered call include the following:
- It provides a barrier against a lower market price in shares.
- Income is somewhat predictable allowing the seller to budget and plan.
The risks of selling a covered call option are minimal compared to selling naked calls. The biggest risk could be viewed as more of an opportunity cost. While the premium on the established strike price is an overall benefit, it could limit your profit if the market price of the stock climbs well above the strike price.
Make Money Selling Call Options
As established throughout this article, by selling covered call options, the seller is guaranteed to instantly generate money. If the seller is a fluent trader, he or she might choose to use that upfront cash to reinvest in other promising stock. Furthermore, traders can sell covered calls as a means to add additional funds to a retirement account since premiums earned through the sale are viewed as investment income and therefore, do not go against the annual contribution limit.
Regardless of the route the seller chooses to take, selling covered call options is a great way to use others’ money to grow your account and financial investments while decreasing the risk that always come with trading in the market.
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