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Friday September 03, 2010 |
Basic
Strategies for Options - Selling Calls
In
the previous lessons we learned the advantages and the
circumstances under which an investor may choose to buy option
contracts. In this lesson we will learn the basic strategies associated
with selling option contracts.
Let's
review some basic concepts. As
a call option seller or "writer" one assumes the
obligation to sell a specific stock at a specific price for a
fixed period of time. In
exchange for assuming this obligation the writer is paid a premium
at the time the call or put is sold.
Covered
Call Writing
The
covered call write is the most common option writing strategy and
is considered to be even more conservative than buying common
stock outright because the strategy provides some measure of
downside protection. But
first things first, what is covered call writing and who should
use this type of strategy?
If
a long-term investor owns a position in a common stock he may
supplement his return on that investment and/or gain some downside
protection by selling the right to buy that stock at a specified
price, for a fixed period of time in the open market. For selling this right the covered call writer gets a
premium but foregoes possible appreciation in the price of the
common stock. That
may sound a little technical so consider this example.
A
conservative investor owns 100 shares of IBM bought at $90 per
share. The common stock is currently selling at $100 per share. The investor wants to hold IBM shares for the long term but
feels the stock price is unlikely to rise significantly over the
next two months. It
occurs to him that a good way to supplement his return on his IBM
investment is to sell the right to buy his shares at a higher
price during the next two months. He determines a price at which he would be happy to sell
IBM shares and then determines if he can capture additional income
by selling the respective call option. After scanning the option tables in his local newspaper he
realizes that the IBM January 110 calls are priced at $2 per
contract. He happily
sells this contract the next morning at $2, creating an obligation
to sell his holdings in IBM common stock at $110 for the next two
months. Now let's run
through the possibilities.
1. Our covered call writer is correct and IBM common stock
does little for the next two months. In fact, at the expiration date in January the common stock
is trading at $107. If he chooses to sell his common stock in the open market our
covered call writer earns a profit of $1,900 (proceeds from the
sale of IBM stock at $107 ($10,700) plus the proceeds from selling
the IBM January 110 calls at $2 per share ($200) less his initial
cost ($9,000)). Because
the common stock did not close above $110 at the January
expiration date the previously written option becomes worthless
and the obligation null and void. Also, our covered call writer is under no obligation to
sell his shares in the open market, he may hold his position as
long as he wishes to do so.
2. IBM stock is much stronger than our covered call writer
anticipated, the price advances sharply, rallying to $120 by the
January expiration date. Our
covered call writer is assigned and his shares in IBM are called
away at $110. Although
our covered call writer was wrong about the IBM stock price he
still earns a tidy profit of $2,200 from this strategy (proceeds
from the assignment at $110 ($11,000) plus the proceeds from the
sale of the IBM January 110 calls ($200) less his initial cost for
IBM common stock ($9,000)).
3. IBM stock comes under pressure and falls to $85 by the
January expiration date. Our
covered call writer was not anticipating this turn of events but
he is still better off for having written the IBM January 110
calls. These calls
decline to zero because the right to buy IBM stock at $110 when it
can be bought in the open market at $85 is worthless. The decline in price for IBM means that our covered call
writer now has an unrealized loss of $300 (proceeds from possible
sale of IBM common stock in the open market at $85 ($8,500) plus
the proceeds from the sale of the IBM January 110 calls ($200)
less the initial cost for the IBM common stock ($9,000)). The covered call strategy offsets the loss by the value of
the premium received.
For
the sake of simplicity each of the examples above assume the
writer maintains the strategy until the January option expiration
date but in reality this may prove unwise. For example, if the common stock falls significantly the
writer may wish to terminate his obligation under the terms of the
written contract and sell his shares in the open market to avoid
loss. He can do this by simply executing a closing transaction that is, buying back
the original written contract in the open market. If the share price has fallen the previously written call
should have significantly diminished value.
As
illustrated above, a covered call writer's potential profits and
losses are significantly influenced by the strike price of the
call he chooses to sell and the price movements of the underlying
common stock but under all circumstances the writer's maximum net
gain will be realized if the stock price is at or above the strike
price of the covered call option at expiration or at assignment.
In
our example we used an out-of-the money call but the covered
writer is not restricted to using such options in a covered write
strategy. When
choosing a strike price to sell the following rules apply assuming
the purchase and current stock price are the same:
1. If the covered writer sells an at-the-money call his
maximum profit is the premium he receives for selling the option. This strategy is useful if the covered writer believes the
stock price is likely to decline modestly over the life of the
written contract;
2. If the covered writer sells an in-the-money call his
maximum profit is the premium minus the difference between the
stock purchase price and the strike price. This strategy is useful if the covered writers' primary
concern protecting his long stock position against a substantial
decline over the life of the contract;
3. If the covered writer sells an out-of-the-money call his
maximum profit is the premium plus the difference between the
strike price and the stock purchase price should the stock price
increase above the strike price. This strategy is useful if the covered writer is modestly
bullish and believes the common stock will show only minor
appreciation over the life of the contract.
Writing
covered calls can be a very powerful strategy for conservative
investors but investors choosing to build such strategies should
be prepared to sell stock in accordance to the parameters of the
contract that has been written. Furthermore, If the writer is assigned, his profit or loss
is limited to the amount of the premium received plus the
difference, if any, between the strike price and the original
stock price. If the common stock price rallies above the strike
price of the option written and the stock is called away the
writer forgoes the opportunity to profit from further increases in
the stock price unless he makes a closing transaction to terminate
his obligations. If the stock price decreases, his potential for
loss on the stock position is limited only by the amount of the
premium income received.
Uncovered
Call Writing, the Naked Write
Selling
a call obligates the writer to sell shares of the underlying
common stock at a specified price for a fixed period of time upon
assuagement. If the
shares are owned by the writer this can be a very conservative
strategy – but what happens when the writer does not own the
underlying shares?
Unlike
the covered writing, uncovered writing, often called "naked
writing" is a very speculative strategy because potential
profit is limited to the premium received and potential losses are
unlimited. The purpose of this strategy is singular, to realize income
from the writing transaction without committing capital to the
ownership of the underlying stock. Because this strategy is considered extremely high risk,
the naked writer must maintain minimum margin requirements to
ensure that the underlying common stock can be purchased
throughout the life of the contract.
What
exactly is naked writing and why is the strategy so high risk? Better still, for whom is the strategy suitable? Naked writing involves selling the right to buy shares of
the underlying common stock at a specified price, for a fixed
period of time. Although
the naked writer has assumed an obligation to sell the underlying
security if assigned, he does not own the stock. In effect, the naked writer is betting that the stock will
decline over the life of the contract and the premium will be
collected without obligation.
Naked
call writing can be very profitable during periods of general
market weakness but potential writers should be aware of the
significant risk inherit in this strategy. First, if the stock rises suddenly there is a good chance
the written calls will be exercised and the naked writer will be
forced to either buy the underlying stock in the open market to
fulfill his obligation or make a closing transaction by buying the
written calls in the open market. In both cases the odds are good these transactions will
result in a substantial loss. Second, because the naked writer is obligated to sell the
underlying common stock if assigned margin requirements are high
and these requirements fluctuate daily with the price of the
underlying common stock. The
naked writer will be subjected to potentially large margin calls
and as such may be forced to close the position prematurely. Consider the following example.
An
investor is scanning the option page of his local newspaper when
he reads that the Yahoo! December 230 call is trading at $10
despite the fact that the common stock is trading for just $210. After first thinking the price must be a typographical
error he decides to explore further. Sure enough, the price is legitimate and he races to phone
his broker to sell one contract despite the fact he does not own
Yahoo! Common stock. He
feels this is as close as he will ever come to found money in the
option market. Let's
run through the possibilities.
1. Our naked writer is absolutely correct and Yahoo! common
stock does not rise to the $230 level ahead of the end of the
December expiration date. Our
naked writer collects the entire premium of $10 per contract
($1,000). Because the
price remained below the strike price for the option written he
was not assigned.
2. Yahoo! common stock surges unexpectedly after the company
announces a stock split. The
common stock reaches $300 per share by the December expiration
date and our naked writer soon comes to understand why the option
premium had been so large. He is forced to buy the stock in the open market and sell it
at a lower level as per the parameters of the naked contract. The resulting loss is a whopping $6,000 (cost of purchasing
Yahoo common stock in the open market at $300 per share ($30,000)
less proceeds from the call assignment at $230 per share ($23,000)
plus the proceeds from the sale of the Yahoo December 230 calls
(1,000)).
Of
course we must not forget that the naked writer has the ability to
terminate his obligation under the terms of the written contract
by simply executing a losing trisection. He can also mitigate his risk at any time during the life
of the option by purchasing the underlying shares of stock,
thereby becoming a covered writer.
Writing
uncovered calls or the naked write is an inherently high-risk
strategy that should be employed by only the most sophisticated of
investors. If the
writer is correct about the direction of the underlying common
stock the profit potential can be huge but option pricing is based
on time-tested mathematical models, just because a premium is
large does not mean it is unwarranted.
buying puts
advanced
strategies
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Bearish Strategies > Selling Calls
