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How Call Options Work III – Call Option Writing

To complete the “How Call Options Work” series, Preet now briefly explains the process of call writing.  This is Part 3 of 3.  In case you missed the earlier articles, here is Part 1 and Part 2.

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 1How Call Options Work – The Basics

Part 2How 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!







15 Comments, Comment or Ping

  1. Preet, how would a small time investor with an online discount brokerage account “write” a call option?

  2. First you have to make sure your account is approved for options trading – if not, you can generally find a button or link somewhere in the account details section that will allow you to apply to make changes to your account.

    Next, when you go to enter in a trade – just change the market to the Options market and fire away: you will have the option of buying or selling, calls or puts.

    Your online broker will have a drop down list available (usually) once you enter in the option symbol – you will be able to select from a number of strike prices.

    Options trade just like stocks – so you can enter “good through” orders, Limit or Market orders etc.

    Some online brokers may not allow you to hold naked positions – which will help you from blowing up, but not all do, and you can’t assume that because they allow you to enter a trade it means it is a conservative option stragegy – so make sure to do your homework thoroughly! :)

    If anyone is interested in trading options for the first time, you would want to visit the Montreal Exchange’s website and download the Options Guide first, read it and then execute your first few trades with one of the telephone-based traders. It will cost you a few extra bucks, but you really want to make sure you start out correctly and avoid making mistakes. Once you get more comfortable, it will be as easy as trading a stock.

    A good list of all tradeable options can be found on the Montreal Exchange’s website too as Derek pointed out in a comment of the first part in the article.

    Click here to download the Options Guide from the Montreal Exchange

    Click here to look up all the options you can trade.

  3. Thanks for the detailed reply Preet, I will check out the links.

  4. 4. Gates VP

    Wow man, this was great series. My step-father was a broker and did quite a bit of options trading, however I never really mentally mapped out the call/put thing until lately.

    This article series was good and clear though, I could show this to my fiancé and she would get it.

    Only -ve comment (which I’ve used before), would be to have pictures, even just text and arrows made in Paint. I know that it sounds like a pain in the butt, but from my teaching experience, a lot more people will “get it” if they see drawn. Just my $0.02.

    But thanks for the great writing.

  5. Gates VP – I totally appreciate your comment. The extra amount of time it takes to create custom graphs can actually double the time to write a post for me – I’m a bit OCD, so I would fuss over it for a while.

    If I had the luxury of more time – I would incorporate graphs and pictures and drawings into all posts – but unfortunately, I’ve had to “draw the line” as it were, with just the writing.

    Maybe I will cut down the posting frequency and increase the supporting content. I think you are right – more people would have a better time understanding some concepts with some simple diagrams as not everyone learns in the same way (auditory, visual, etc.).

    Thanks for the kind words too! They give me motivation to keep on writing.

    I will incorporate your suggestion about the graphs and diagrams into a book I’m writing – it is on RRSP’s and covers about 30 or so planning strategies, the ins and outs, etc. It is aimed at advisors AND investors and I need to make it easy to understand for as many people as possible. I was on the fence about adding graphs and diagrams, but I think that was just me trying to find the easy way out. Your comment made me realize that the ROI of adding the graphs/etc is worthwhile – thank you.

    Preet

  6. 8. Colleen

    I have done covered calls in my RSP and LIF self directed accounts and do bear call credit spreads in my regular accounts. Are credit spreads still consider ‘naked’ becuz you don’t actually own the stock or are they considered ‘covered’ if on a 45.00 stock you were to purchase a 55.00 call option and sell a 50.00 call option on the stock you expect to continue going down. This essentially covers you if the stock price were to rise and break through the 50.00 strike price and limits your losses being able to buy the stock at 55.00. Are these types of trades allowable within a RSP account? thanks

  7. 9. DG

    Excellent series on call options, especially Part III on covered call writing. Thanks!

  8. Colleen: I’m not the biggest fan of bear call spreads – to be honest I would rather buy a blue chip stock with a fat dividend… but:

    Bull Call spreads aren’t considered naked (at least not in my eyes – purists might make a distinction between covered and protected), I take the position that they are *protected* as opposed to *covered* (which accomplish the same thing) so long as the two option contracts have the same expiry date.

    You would have to check with your brokerage company to see what kind of trades they allow in your accounts. For example, the last time I checked, a large discount broker did not allow collars, straddles, or strangles, etc. in any types of accounts.

    Your brokerage company will have a policy and guidelines brochure online to address all your questions.

    Hope that helps! :)

  9. 12. AL

    I often write call or put options and then later cover them with a higher or lower strike price option. Are these types of spreads allowable in an RRSP account…ie. does going long on a lower stike price oprion cover a higher strike price option in an RRSP account????

  10. Al, yes, you can trade options within an RRSP account providing that you selected that option when you opened the account.

  11. 15. Ronan

    Just came across this and have to point out a couple of issues. The first is with the statement “It is an alternative way to set a “limit sell order”.” This is false, as generally it is never optimal for an option holder to exercise early. However, if you leave an offer in the market to sell at a given price, the market can’t trade through your level without your shares being sold. Using the example from the article, lets say you sell a call with a strike of $60 on a stock trading at $50. The life of the option is 3 months. 2 months from now, the stock has rallied to $70, when it announces terrible earnings and plummets back to $50. When the stock was at $70, the option would have been worth $10 + time value, so the holder could exercise and make $10, or sell the option and get $10 + time value. The result is the holder doesn’t exercise, you haven’t sold your stock, though you have received your premium. The other issue with covered call writing is that it takes away the upside of the equity (which is why you are investing in equities in the first place!) and leaves you all of the downside. Brokers like covered call as it generates a steady stream of commission revenue, but I struggle to see why a retail investor would get involved. If you put together a portfolio of carefully researched stocks, why would you give up your upside for relative peanuts?

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