The world of options trading requires the two components that trading of any kind needs – a buyer and a seller. While you may have done your fair share of research when it comes to the buying of options, it is worthwhile to learn more about being a seller of options. In particular, the selling of call options requires certain strategies that allow the seller to make profit in specific market conditions. Here is all you need to know about selling options.
What is a Call Option?
In order to seek an answer to the question ‘what is selling call options?, let us review the basic concept of call options and how they are relevant for an investor.
We know that options are financial instruments that derive their value from an underlying asset. A call option is essentially a type of derivatives contract that gives the option buyer the right, but not the obligation, to buy that asset at a specific price (known as the strike price) on or before a specific date of expiration. In the context of the stock market, the process of selling calls options often takes place in lots of 100 shares.
Selling Call Options
Now that we have reviewed the topic of call options, let us delve into the skill of selling call options. The first point of note is that while the buyer of a call option does not have an obligation to purchase the asset, the seller of a call option does have an obligation to sell it when the buyer chooses to exercise his right. This right can be exercised by the buyer anytime before the expiration date and at the specified strike price.
The price that a seller receives for the option is based on how likely the option buyer is to make a profit by exercising his right to purchase before the expiry of the option. This is determined by how close the strike price is to the price of the underlying asset at the time the option is bought and the amount of time remaining till the expiry of the option.
For an options seller, the key to selling call strategy is to hope that the price of the asset declines and the option becomes worthless before the expiration date. This allows him to keep the money received for selling the option, or premiums, as profit. This means that while selling calls does not multiply your money in the way that buying calls does, it does earn you profit in the likely event that the asset’s price falls or even stays flat. Hence, the ideal time for when to sell call options is when your outlook for an asset is that it will not be rising in value before the expiration date.
Types of Selling Call Options
While selling call option strategies can differ from investor to investor, there are two main ways in which an investor can sell call options:
Covered Call: In this selling call strategy, the seller owns the underlying asset of the call option. This strategy of selling calls is therefore considered low risk because the seller has previously purchased the asset at a price that is lower than the strike price. He is therefore “covered” against the risk of loss and can receive the profit as additional income.
Naked Call: As opposed to the covered call, the seller does not own the underlying asset of the call options. As a result, this selling call strategy is considered fairly high-risk since the seller is not protected from potential losses through ownership of the asset.
While these two types of selling call strategies might differ in terms of risk, they both come with their own pros and cons. For instance, the selling call strategy with naked calls often comes with lower upfront costs since the associated risks are high. On the other hand, selling call options with covered calls ensures that the seller is in a secure position, regardless of the direction of the asset’s price movement.
Selling call options can be an essential part of being an options trader, which is why it is important to develop your own selling call option strategy over time. Moreover, timing is everything when it comes to selling call options which means that knowing when to sell call options is just as important as knowing which call options to sell. Above all, make sure to exercise caution and do your fair share of market research before taking up the challenge of selling call options.