Selling Calls: Conservative and Profitable
The idea of going short -- selling first, and buying to close later -- is a tough idea to grasp. Most of us think about investing in a precise sequence. First, you buy a security; then, at a later date, you sell. If the sale price is higher than the purchase price, you earn a profit; if it is lower, you suffer a loss.
By starting out the sequence with an opening sale transaction, you are paid the premium at the time the order is placed. You will pay a purchase price later when you close the position or, if the option expires worthless, you never pay at all. In that case, the entire sale premium is yours to keep as profit. If this all sounds like a pretty good deal, you also need to remember that taking a short position is accompanied by inevitable risks. Some types of call selling are extremely high risk and others are very low risk and conservative.
Call sellers enjoy significant advantages over call buyers. Other articles have demonstrated how time value works against the buyer; in fact, the time value premium makes it very difficult for buyers to earn profits with options; the odds are against them. The problem of declining time value is the primary risk of option buying. Even when the underlying stock's market value moves in the desired direction, it might not happen soon enough or with enough point value to offset the time value premium. This buyer's disadvantage is the seller's advantage.
Smart Investor TipSellers receive payment when they initiate the opening transaction. That is compensation for accepting exposure to the risks.
Because time value evaporates, buyers see time as the enemy. For sellers, though, time is a great ally. The more time value involved, the higher the potential profit; and the more that time value falls, the better. When you enter the order for an opening sale transaction, you are better off if you have the maximum time value possible. While buyers seek options with the lowest possible time value and with the stock's market value within reasonable proximity to striking price, sellers do the opposite. They seek calls with the highest possible time value and the largest possible gap between striking price of the option and market value of the stock.
When you sell a call, you grant the buyer the right to buy 100 shares of the underlying stock at the striking price, at any time prior to expiration. That means that you assume the risk of being required to sell 100 shares of the underlying stock to the buyer, potentially at a striking price far below current market value. The decision to exercise is the buyer's, and that decision can be made at any time. Of course, as long as the call is out of the money, it will not be exercised. That risk becomes real only if and when the call goes in the money (when the stock's market value is higher than the call's striking price).
Smart Investor TipTime is the buyer's enemy, but the opposite is true for the seller. The seller makes a profit as time value evaporates.
All investment strategies contain specific risk characteristics, and these should be clearly identified and fully understood by anyone undertaking the strategy. The risks tend to have unchanging attributes. For example, the risks of buying stocks are consistent from one moment to another. The experienced stock market investor understands this and accepts the risk. However, call selling has a unique distinction. It can be extremely risky or extremely conservative, depending upon whether you also own 100 shares of the stock at the time you sell the call.
ExampleStuck with the Strike: You sold a call two months ago with a striking price of 50. At the time the stock's market value was $46 per share. At the beginning of this week, the stock had risen to $58 per share and the buyer exercised your call. You are required to deliver 100 shares at $50 per share. If you own 100 shares of stock, you relinquish ownership and receive $50 per share rather than current market value of $58. If you do not own 100 shares, your brokerage firm will complete the transaction and deduct the difference from your account, or $800 ($58 per share current market value less striking price of $50 per share). Transaction fees will also apply.
By Michael C. Thomsett