Selling a call creates the obligation to sell the stock at the strike price. Why is a trader willing to accept this obligation? The answer is option premium.If the position is held until expiration without getting assigned, the entire
premium represents a profit for the trader. If assignment occurs, the trader will be obliged to sell stock at the strike price. If the trader does not have a long position in the underlying stock (a naked call), a short stock position will be created. Otherwise, if stock is owned (a covered call), that stock is sold.
Whether the trader has a profit or a loss depends on the movement of the stock price and how the short call position was constructed.Consider a naked call example:Sell 1 TGT October 50 call at 1.45 In this example, Target Corporation (TGT) is trading at $49.42. A trader, Sam, believes Target will continue to be trading below $50 by October expiration, about two months from now. Sam sells 1 Target two-month 50 call at 1.45, opening a short position in that series.
Exhibit 1.3 will help explain the expected payout of this naked call position if it is held until expiration.If TGT is trading below the exercise price of 50, the call will expire worthless. Sam keeps the 1.45 premium, and the obligation to sell the stock ceases to exist. If Target is trading above the strike price, the call will be in-the-money. The higher the stock is above the strike price, the more intrinsic value the call will have.
As a seller, Sam wants the call to have little or no intrinsic value at expiration. If the stock is below the break-even price at expiration, Sam will still have a profit. Here, the break-even price is $51.45—the strike price plus the call premium. Above the break-even,Sam has a loss.Because a short stock position may be created, a naked call position must be done in a margin account.
For retail traders, many brokerage firms require different levels of approval for different types of option strategies. Because the naked call position has unlimited risk, establishing it will generally require the highest level of approval—and a high margin requirement.Another tactical consideration is what Sam’s objective was when he entered the trade. His goal was to profit from the stock’s being below $50 during this two-month period—not to short the stock.
Because equity options are American exercise and can be exercised/assigned any time from the moment the call is sold until expiration, a short stock position cannot always be avoided. If assigned, the short stock position will extend Sam’s period of risk—because stock doesn’t expire. Here, he will pay one commission shorting the stock when assignment occurs and one more when he buys back the unwanted position.
Many traders choose to close the naked call position before expiration rather than risk assignment.It is important to understand the fundamental difference between buying calls and selling calls. Buying a call option offers limited risk and unlimited reward. Selling a naked call option, however, has limited reward—the call premium—and unlimited risk. This naked call position is not so much bearish as not bullish.
If Sam thought the stock was going to zero, he would have chosen a different strategy.Now consider a covered call example:Buy 100 shares TGT at $49.42 Sell 1 TGT October 50 call at 1.45 Unlimited and risk are two words that don’t sit well together with many traders. For that reason, traders often prefer to sell calls as part of a spread.But since spreads are strategies that involve multiple components, they have different risk characteristics from an outright option.
Perhaps the most commonly used call-selling spread strategy is the covered call (sometimes called a covered write or a buy-write). While selling a call naked is a way to take advantage of a “not bullish” forecast, the covered call achieves a different set of objectives.After studying Target Corporation, another trader, Isabel, has a neutral to slightly bullish forecast. With Target at $49.42, she believes the stock will be range-bound between $47 and $51.50 over the next two months, ending with October expiration. Isabel buys 100 shares of Target at $49.42 and sells 1 TGT October 50 call at 1.45.
The implications for the covered-call strategy are twofold: Isabel must be content to own the stock at current levels, and—since she sold the right to buy the stock at $50, that is, a 50 call,to another party—she must be willing to sell the stock if the price rises to or through $50 per share. Exhibit 1.4 shows how this covered call performs if it is held until the call expires.The solid kinked line represents the covered call position, and the thin, straight dotted line represents owning the stock outright.