What I have described above has been focused on when you BUY a call option contract.
But you should know that investors have the option of SELLING call options too. This is commonly referred to as Call Option WRITING. In this case you would sell the contract and collect the premium (as opposed to BUYING the contract and PAYING the premium).
The option buyer would have the option of buying your shares before the expiry date, and you would be OBLIGATED to sell your shares to them. If the stock never reaches the strike price, the contract expires worthless to the option holder (although you will have kept the premium no matter what – and still own the stock in the case of a “covered” call write).
Covered Call WRITING (as opposed to buying) has one particularly interesting use:
It is an alternative way to set a “limit sell order”.
Instead of instructing your broker to sell when your stock gets to a certain point, you can just WRITE or SELL a call option and pick up some additional revenue (the price you get for the contract) to boot. When the stock reaches the strike price, the option holder will exercise their right to buy the shares and you will be forced to sell – again: great if you were instead planning on setting a limit sell order.
For example if you bought a stock for $50 and thought that when/if it reaches $60 would be a good time to sell, you might instruct your broker (or trading program) to automatically sell at $60. In that case you will have made a gain of 20% ($10 gain on $50 investment – ignoring commissions).
On the other hand, if you bought the stock for $50 and instead WROTE a call option with a strike price of $60 and sold that contract for $2.50 – then assuming the stock appreciated to $60 the option holder would exercise their option to buy at $60 and you would be forced to sell. You will have collected a $10 gain from the stock and the $2.50 premium from selling the option contract for a total gain of 25% as opposed to 20%. An extra 5% gain, with no added risk.
In fact, the gain could be higher if the call option expires before reaching the stock price. If that were the case, you would keep writing the call options on an ongoing basis and keep pocketing the premiums along the way. If the second call option you wrote was exercised then your gain would be 30% ($10 gain from the stock + [ 2 x $2.50 per contract ] ).
Many investors will just keep writing covered calls and collecting the premiums over and over again. When a contract expires, they will turn around and write another one. If you have used this strategy on BCE for the last 5 years (before the run-up) you would have collected not only the healthy dividend from BCE’s stock, but also the ongoing premiums for countless expired call option contracts that you wrote time after time (since the stock was essentially flat for 5 years).
This is called “COVERED Call Writing”. “Covered” means that you own the stock. If you did not own the stock it would be called “Naked Call Writing”. Naked Call Writing can be a VASTLY RISKIER proposition because if the stock’s price increases dramatically you will be forced to sell shares at the strike price (by short selling) and then covering your short at a higher stock price.
Let’s look at an example of Naked Call Writing:
You do not own ABC which is trading at $50, but you decide to write a naked call option contract with a strike price of $54 and an option premium of $2, expiring in 4 months. If ABC doesn’t get to $54 within 4 months, you will have pocketed the $2.
BUT, let’s say that ABC shoots up one day to $60. In this case, if the option holder exercises their option of buying ABC at $54, then you must provide ABC to them at $54/share. In order to deliver the shares, you will need to buy ABC on the open market at $60/share. Therefore, you bought at $60, and sold for $54 for a $6 loss. You still pocket the $2 for selling the option contract in the first place, so that reduces your loss from $6 to $4.
You can see from this example that if the stock moves significantly, your losses can be extreme! I would suggest thinking LONG and HARD about naked positions – how’s that for a double-entendre! :)
As you can see the world of options is an interesting one. And there are MANY other option strategies that we have not mentioned – some for engaging large amounts of leverage and enhancing returns, and some for mitigating risk by hedging your portfolio or through other means. All in all – options present many interesting opportunities for investors of all risk levels – so if you had always thought that “options are too risky for me” – you may want to learn more about them.
Thanks for reading this guest article – I recently wrote about an advanced option strategy on my own blog (WhereDoesAllMyMoneyGo.com) that talks about how you can use options to make a gain when you know a stock is about to make a dramatic move in price – but you just don’t know which direction that move will be! This is known as an “Option Straddle”.
Take care everyone – and thanks to FT for offering me the opportunity to guest-author another article for Million Dollar Journey!
Part 2: How Call Options Work – Examples
As you guys can see, Preet really knows what he’s talking about as he lives/breathes/eats the stock market. Check out his blog @ WhereDoesAllMyMoneyGo and you won’t be dissappointed. Thanks Preet for the time and effort put into the articles!