Order Entry: Credit
Ideal Environment: High IV
Profit Target: 50%
Definition: An agreement that the seller of the call option will sell a stock at a specified strike price and quantity on or before a particular date if the price of the stock is above the strike price.
Each stock option covers 100 shares of the underlying stock.
Selling Call Options
The “writer” of the call option is obligated to sell the stock to the buyer if the option is in-the-money and the buyer so decides. The seller collects a fee (premium) when creating the call option for the risk associated with this obligation.
The risk of selling call options is having to sell stock to the buyer at the lower strike price. If the seller owns zero of the underlying security, the loss is equal to (current stock price-strike price) x (100 shares/contract). This loss is potentially unlimited.
Selling call options is profitable when the options sold expire worthless. The seller gets to pocket the premium. This occurs when the stock price never reaches the strike price by the expiration date. This is why people usually sell OTM call options.
As a seller of the option, the trader does not have to hold until expiration. The seller of the call is allowed to buy back the call option at a lower price for a smaller profit.
An advantage of selling options is positive theta decay (time value). As the option approaches expiration the time value portion of the option decreases. This is good for the seller of the option because if the stock does not move, they can buy the call option back for less than they sold it for and net profit the difference.
Selling OTM calls has a higher probability of success, but has a lower ROI.
In order to breakeven during the sale of an OTM call option, the price of a stock has to appreciate up to the strike price plus the premium collected.
Breakeven Stock Price = Call Strike Price + Premium Collected - Commissions
As the stock price stays at the same level or declines, the value of the call goes down. The time value portion of the option loses value as the option gets closer to expiration. The intrinsic value goes down as the stock price goes down.
The maximum profit is if the option expires worthless, therefore the trader gets to keep all of the premium sold. The trader can also buy back the call at a lower price for a smaller profit at any time before the expiration date as well.
Profit =Higher Premium Collected (initial sale) – Lower Premium Purchased (buying option back) - Commissions
If the stock goes up or volatility expands, the trade may still result in a small loss. The intrinsic value of the option or the time value of the option may get more expensive.
Loss = Lower Premium Collected (initial sale) - Higher Premium Purchased (buying option back) – Commissions
Potentially the loss is unlimited because the upside of a stock does not have a cap. Therefore, selling naked short calls is considered a riskier trade.
Max Loss = Unlimited = Premium Collected – ((Stock Price – Breakeven Stock Price) X 100 shares/contract)