Selling Call Options
In earlier articles, we explored the basics of call options and put options. We learned that call options increase in value when the value of the underlying asset increases. We also learned that put options increase in value when the value of the underlying asset decreases. Option investors can profit by buying options but they can also profit from options by selling them.
Consider a call option on company ABC that has a premium of $5. The option expires in December and has a strike price of $20. The stock currently trades at $18. If you sold the call option today, you would pocket $5. If the stock remains below $20 at expiration, you keep the full $5. If the stock is above $20 at expiration, your position will be worth less than the $5 premium you received depending on where the stock trades. Suppose the stock is at $30 at expiration. The option you sold will be exercised meaning the holder will buy stock from you for $20. Since you do not currently own any shares, you will have to buy them at the current market price of $30 only to sell them at $20. You've lost $10 on this trade even though you made $5 on the option premium. All in all, you lost $5 ($5 premium - $10 loss on exercise and repurchase of shares = -$5).
As you can see, selling options can be away to lock in a fixed gain on a transaction. However, if the trade moves against you, the gain from the premium can be offset by covering your position. Remember, there are no guaranteed returns in option trading so be careful.
Reuben Advani is the president of The BARBRI Financial Skills Institute and the author of two finance books. More information on this and other topics can be found at http://legalpractice.barbri.com.