Option Basics Part 3: Selling a Call Option
I am addicted to selling options. In this post, you will learn all the reasons why you should never do it, and then the strategy I use when selling calls.
Selling an option is less intuitive than buying an option. However, if you understood how buying a call option worked in part 1, you can understand selling a call. Selling a call option is literally taking the opposite side of the trade to someone buying a call option. You two are counterparties to each other on a zero-sum gain contract.
The option contract is either exercised or not by maturity, which means there is a winner and loser. If the payoffs and profits of buying a call option make sense, selling a call will be the exact same numbers, but flip the sign. All the negative profits (ie-losses) to the option buyer are positive profits to the option seller and vice versa.
What is Selling A Call Option Naked?
When you sell a call option, you want the stock to go down. Selling a call option is betting that the price of the underlying stock will be below the option strike price at maturity. When you sell an option you get a premium today. That is your total possible gain. No matter what happens, the most you stand to profit is the premium you receive. This is a very important point to reiterate.
“When you sell a call option, the premium you receive is your total possible gain. You get no additional upside if the stock price goes lower, but are exposed to all the potential losses if the stock price goes higher”
The higher the stock price goes, the more losses you accumulate. However, if the stock price goes lower, you don’t get any additional gains. Because of this asymmetric return downside, selling options have been compared to “picking up nickels in front of a steam roller”. You are collecting small premiums (nickels) and have the looming inevitable threat of being crushed from a big stock move against you (the steam roller).
Asymmetric Returns On Options
All naked option positions have asymmetric returns.
Lets go back to being the option buyer for a second. When you buy a call or a put, you are paying a premium, which is a fixed amount. However, you have the potential for extremely outsized gains. (See Part 1: Buying a Call or Part 2: Buying a Put if you need a refresher). A fixed downside with huge potential upside is a positive asymmetry of returns.
Compare this to a more symmetrical return profile of stocks that you are likely familiar to.
If you buy a stock and the price goes up $1, you gain $1. If the price goes down $1, you lose $1. That is symmetrical returns and if you assume the probability of going up and down is the same, you wind up with a bell curve like below.
(Note - yes I am very aware that a Normal distribution is not what stocks actually exhibit. It is a simple way to visualize symmetry though.)
Compare that to an at-the-money call (stock price = strike price). The current payoff on that option is $0. If the stock goes down $1, your payoff is still $0. However, if the stock goes up $1, you gain $1. If the stock goes down $2, your payoff is $0, but up $2 you gain $2. This is not symmetrical since the payoff is different for the same sized moves in the stock.
Buying options gives you positive asymmetry of returns.
Selling options gives you negative asymmetry of returns.
Remember, buying and selling an option is taking different sides of the same contract. If the option buyer has a fixed downside and huge upside. Then the option seller has a fixed upside and huge downside. Your exposed to huge potential losses.
“Selling an option is like picking up nickels in front of a steamroller”
-Buffet…or Munger…or Ghandi… or some famous guy who gets credit for quotes he probably read from a small twitter account and ripped off to their larger audience
Hopefully I have belabored the point enough about the risk of a naked short call position.
Selling a Call Option Example:
Below is the same example used in part 1, but this time you are a seller of the call option rather than a buyer. The stock is sitting at $4.50 today, and you think it is over valued and has a low chance of increasing to $5. You are able to profit $25 over 1 month if you are correct and the price is at or below $5.
However, look at the downside if you are wrong and the stock rips higher. If the price of the stock increases to $6, your net loss is $75. If the stock gets some surprise good news and rips, you could be out many multiples of the premium you received.
Call Option Seller’s Profit:
The graph below shows the profit for selling the above call option. Your max gain is $25. When you sold the call on a $4.50 stock it looked pretty safe as:
The $5 strike is over 10% out-of-the-money. ($5/$4.5). Therefore, you were thinking the stock wouldn’t increase greater than 10% in a month. A 10% move in a stock in a single month is a fairly sizable buffer.
Additionally, you start losing money at $5.25 stock price since you get the $25 premium upfront. That requires over a 15% move in the stock before you start losing money ($5.25/$4.5).
The $25 premium is 5% '“return” on $500 strike.
Note-depending on how you have your account set-up at your broker, will dictate the rules around selling options. At the highest level, you can sell options naked (not hold the underlying stock) by using borrowed money. That is outside the scope of this post. I used the $500 strike to calculate the return just to help give some intuition around the size.
Therefore, you are taking a 5% monthly “return” today and betting the stock doesn’t go up 15% in a month, very loosely speaking.
Takeaways from the call option seller’s profit graph include:
At all stock prices below the strike price of $5, the option position profits $25
When the stock price = strike price, the option profit starts linearly decreasing as the stock price increases
When stock price = strike price + option premium, the option starts becoming a net loss (crosses the x-axis, $5.25 in the above example).
The option payout decreases dollar-to-dollar with the increases in stock price over the $5
Why Would You Ever Sell A Call Option?!?!?
Small potential gains and an unlimited potential loss. Who would ever sell a call option?
I would and do. Selling calling options are a core strategy I deploy in my portfolio.
However, there is one MAJOR caveat. This post is viewing the short call option position in isolation. I would never sell a call option naked and leave myself open to unlimited losses.
If you own 100 shares of the underlying stock and sell a call option against it, you have prevented yourself from a loss on the option. Worse case, the stock price goes up and at maturity you trade the 100 shares of stock for the strike price to close out your option. This strategy is called a ‘covered call’ and you should read more about it. Seriously, I use it constantly. However, it isn’t ‘risk-free’ since you do have the lost opportunity cost on the stock.
Selling A Call Option Summary
To summarize selling a Call Option means:
You want the stock price below the strike at the maturity date
Your max gain is the premium you received when you sold the call
Your max loss has no limit (in theory)
The option payoff decreases $-for-$ as the underlying stock increases over the strike price
Selling a call option naked opens you up to huge losses
Selling a call option as part of a broader strategy can boost your portfolio cashflow and returns when done well
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