How Call Selling Works

Buying calls is similar to buying stock, at least regarding the sequence of events. You invest money and, after some time has passed, you make the decision to sell. The transaction takes place in a predictable order. Call selling doesn't work that way. A seller begins by selling a call, and later on buys the same call to close out the transaction.

Many people have trouble grasping the idea of selling before buying. A common reaction is, "Are you sure? Is that legal?" or "How can you sell something that you don't own?" It is legal, and you can sell something before you buy it.
This is done all the time in the stock market through a strategy known as short selling. An investor sells stock that he or she does not own, and later places a "buy" order, which closes the position.

The same technique is used in the options market and is far less complicated than selling stock short. Because options have no tangible value, becoming an option seller is fairly easy. A call seller grants the right to someone else -- a buyer -- to buy 100 shares of stock, at a fixed price per share and by a specified expiration date. For granting this right, the call seller is paid a premium. As a call seller, you are paid for the sale but you must also be willing to deliver 100 shares of stock if the call buyer exercises the option. This strategy, the exact opposite of buying calls, has a different array of risks than those experienced by the call buyer. The greatest risk is that the option you sell could be exercised, and you would be required to sell 100 shares of stock far below the current market value.

When you operate as an option buyer, the decision to exercise or not is entirely up to you. But as a seller, that decision is always made by someone else. As an option seller, you can make or lose money in three different ways:
  1. The market value of the underlying stock rises. In this instance, the value of the call rises as well. For a buyer, this is good news. But for the seller, the opposite is true. If the buyer exercises the call, the 100 shares of stock have to be delivered by the option seller. In practice, this means you are required to pay the difference between the option's striking price and the stock's current market value. As a seller, this means you lose money. Remember, the option will be exercised only if the stock's current market value is higher than the striking price of the option.

    Example

    Called Away: You sell a call with a striking price of $40 per share. You happen to own 100 shares of the underlying stock, so you consider your risks to be minimal in selling a call. (If the buyer exercises the call, you already own the shares and would be willing to sell them at the striking price.) In addition, the call is worth $200, and that amount is paid to you for selling the call. One month later, the stock's market value has risen to $46 per share and the buyer exercises the call. You are obligated to deliver the 100 shares of stock at $40 per share. This is $6 per share below current market value. Although you received a premium of $200 for selling the call, you lose the increased market value in the stock, which is $600. Your net loss in this case is $400.

  2. The loss in this example would be viewed based on your original cost of the stock. A call seller selects striking prices based on the original cost of the stock. So if you originally paid $42 per share for the stock and it is called away at $40, you break even before trading costs. (A $2
    By Michael C. Thomsett
    Michael Thomsett is a British-born American author who has written over 75 books covering investing, business and real estate topics.

    Copyrighted 2016. Content published with author's permission.

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