If you sell a call, you give someone else the right to buy a 100 shares or a stock from you at a certain price (strike price), on a certain date (expiration date European style) or until a certain date (expiration date American style). You earn the premium (the strike price times $100). If the stock goes up in price, the call will be exercised. If the stock stays the same or goes down, the call will expire. In either case, you keep the premium.
If you write (sell) a covered call (you own the underlying stock) and the price goes up, you must deliver 100 shares for each call you sold. If the stock goes up less than the amount of your premium, you made a profit on the deal. If it goes up more than your premium, you have an opportunity loss, that is, you could have sold the stock for more than got from the sale and the premium.
If you write (sell) a naked call (you don't own the underlying stock) and the price of the stock goes up, you must still deliver 100 shares for each call you sold. You will have to go out and buy the stock at the market price and deliver it for the strike price. Your risk is unlimited in theory. Once the price goes up more than your premium, you are in a loss position. The more the stock goes up, the more you will lose.
If you are tired of a stock and are near to the price you targeted to sell at, you can write a call to generate a little more gain on the stock. Most brokers who allow you to open IRA's will only allow sophisticated investors to write covered calls. Most of these brokers will not allow you to take a naked position in your IRA.
At first blush, selling a naked call option would appear to be one of the more suicidal gambles any options writer might ever concoct in his imagination. You don't have the stock, and you write a contract to deliver that stock which you don't have. You must have guts of steel! Isn't this practice fraught with heavy risk?
In practice, however, selling a naked call is usually associated with an options strategy that greatly REDUCES risk and enhances profitability. As insurance, naked options are frequently used to prevent potential losses in another investment. Sellers of call options receive cash up front which is his to do with whatever he wants. Typically, the call options seller will use this cash to buy more options, namely put options. Call option premiums are normally MUCH HIGHER than PUT option premiums, since everyone is a perennial BULL. There are many option strategies that involve the sale of one option and the simultaneous purchase of one or more different options. Selling call options is also a strategy employed to impose price reductions on an option transaction. Why pay $500 for a single option, when you can sell one option and use the proceeds to buy another option, with the next result being that you put up less money to capture a sizable profit. In some cases, you can actually get an option position for little or nothing by selling one option and buying another related option. Finally, an expired (worthless) call option may still have value as toilet paper, wall paper, or to doodle upon.
Posted by: Bob Hansell | February 11, 2006 5:31 PM | Permalink to Comment