Sell Call Option Example

Introduction

Let’s listen in on a continuing conversation between two friends about options. In this installment, one friend is trying to explain to the other why somebody would sell a call option.

The Conversation

JH: I’m mostly clear now on the motivations of a call option buyer. Can you explain about option sellers? Why would anybody want to sell a call option?

PE: The main reason is for income. When you own stock, but the market is drifting around aimlessly, you can sell call options against the stock that you own. The premium that you receive, from the buyer of the option, can really help to boost your return.

JH: I think I need an example.

PE: Of course. Let’s use our ongoing example stock, currently trading at $ 130. Our investor owns 100 shares of this stock, and she bought it a few years ago for $ 85 per share. The market is flat. The current premium for the $ 130 call option, which expires in 24 days is $ 3.03. If the investor was willing to sell her shares for $ 130, she could sell one contract of the $ 130 call. She would immediately receive $ 303 from the call option buyer. That represents a 3.5% return on her original $ 85 investment.

JH: So then what happens?

PE: As usual, it depends on what happens to the price of the stock during the remaining life of the option. I suppose the very best case for our investor would be if the stock is just slightly below the $ 130 strike price. In that case, the call option buyer would not exercise the option, and the call option seller would get to keep her shares (and, of course, the $ 303). If the market is still languishing, she could then sell the $ 130 call option which expires the next month out, and receive another nice option premium. If however, the stock price rises above $ 130, then the call option buyer will exercise the contract, and the option seller must sell her 100 shares for $ 130 per share. Regardless, she gets to keep the $ 303. Sell Call Option Example

JH: Which possibility is most likely?

PE: Since the stock price was exactly at $ 130 when our investor sold the call, and the market is flat, I would say that both possibilities are equally likely.

JH: What if the investor would like to have better than a 50% chance of keeping her shares?

PE: If she absolutely wants to keep the shares, than she shouldn’t sell call options at all. However, if she’d like to have a higher probability of keeping the shares, and still make a little money from selling an option, then she could consider selling the $ 135 Call (earning perhaps $ 96) or even the $ 140 Call (bringing in $ 30). Now the stock price would need to move above $ 135, or above $ 140 before the investor would be forced to sell her stock.

JH: This whole selling call options thing is pretty cool. Do you have to own 100 shares of the stock before you sell a call option against it?

PE: Well, it is possible to sell a call when you don’t own the shares, but it’s a really bad idea. It’s known as selling naked calls, and its VERY dangerous. For our investor, when she owns the shares and sells the $ 130 Call, if doesn’t matter whether the stock price goes to $ 135 or $ 535 or anything in between. Above $ 130, she must sell her shares for $ 130. It is a very different story for the naked call seller. He also receives $ 303 when he enters into the contract. If the stock price is at $ 135 on expiration day, then he will need to pay $ 500 to buy back the call option, since he is unable to deliver on the shares. If the stock price should rise as high as $ 535 per share, he must pay $ 40,500 to close the position!

JH: Ouch! I promise never to sell naked calls.

PE: Good. There are other ways to safely sell options, but that’s a story for another day… Sell Call Option Example

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