 Selling Calls Option Strategy
When you are bearish on the market or feel confident that
it won't rise in the short term, you might consider selling
calls to generate additional income. When you hold the
assets for which you are selling the calls, then they are
covered calls and there is limited risk. If you do not hold
the assets, you are selling naked calls and your risk is
unlimited, although your profits are limited. You must be
careful when selling naked calls.
With this strategy, you are selling someone the right to
buy an asset at a fixed price (the strike price), on or
before the expiration date of the option.
This strategy has some nice benefits.
You receive a premium for selling someone the right to
purchase an asset at a particular price that you feel it
will stay below. If the asset price is below the strike
price at expiration, then the calls that you sold are not
exercised and the premium that you collected provides
additional income for you, increasing your rate-of-return.
If you are writing out-of-the-money calls, the asset may
continually increase in value, yet the options may never
get exercised, allowing you to do this over and over again.
This generates continuous income for you, increasing your
portfolio and generating cash flow for other investments.
If the calls that you sold do get exercised, then you are
obligated to sell the asset at the exercise price. But you
essentially sell the asset at a premium from the asset
price that existed when you sold the calls, because you
collected the option premium. You have already agreed that
you would like to sell the asset at the exercise price and
the price is augmented by the option premium that you
collected.
Since you are the seller of the option, the time decay of
the option works in your favor. The time-value portion of
the call premium constantly declines with time, going to
zero on the expiration date. The rate of decay is
predictable and is easily calculated by options analysis
programs such as Option-Aid. As the expiration date
approaches, the rate of decay increases. For this reason,
it is often better to sell calls with one month or less
until expiration. After they expire, you can sell calls on
the next month out and collect another premium if you still
have the same view of the market at that time.
It is also important to cover risks and caveats of this
strategy.
If the asset price rockets skyward and stays above the
strike price at expiration, then the option will probably
be exercised and you will be obligated to sell the asset at
the agreed-on strike price or cover the option, incurring a
loss. If you sold naked calls, your risk is unlimited.
It is important to analyze your expectations for the
underlying asset before selling the call. If you expect the
asset price to remain stable, you can write the call
approximately at-the-money and collect a larger premium.
If you sell an in-the-money call, the premium you
collect will be even larger, but you run a greater risk of
the option being exercised.
When you are analyzing potential option positions, it
helps to have a computer program like Option-Aid that
swiftly calculates volatility impacts, probabilities,
statistics, and other parameters of interest. These
programs can pay for themselves with the first trade that
they help you with.
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