Trading Covered Calls
01/13/2010 12:01 am EST
Option traders frequently start their trading career as options buyers. That can be a great strategy when executed properly, but time value works against you. When you are an option buyer, you have to be right about market direction and about the amount of time it will take the market to move. But did you know that it is possible to be on the other side of the trade as well?
An options writer sells, or "writes," the option contract that option buyers are paying for. By creating the option, the option seller is taking on the opposite responsibilities of the option buyer. If the option buyer wants to “exercise” their option, you as the seller will need to deliver on the contract. That gives the writer an obligation to deliver.
For example, imagine you want to sell a call. The transaction is relatively simple. You would anticipate being paid the bid price, or "premium," for the sale, and now you have the obligation to deliver the stock if the option buyer exercises his option.
There are some distinct benefits of selling options:
1. You get paid your potential profits upfront in the form of the option’s price or premium.
2. If the option expires out of the money, which most options do, then no one will want to exercise the contract and you will keep your entire premium.
3. As time value melts, the decline in the option’s value reduces your liability and risk as the options seller. Because you already sold the option for a high price and took the premium, you can later buy it back for a cheaper price as time value melts, allowing you to exit the trade anytime you like.
4. You can close your trade at any time. All you need to do is to remove the obligation by buying the option back and washing out the trade. This can be done on the open market at any time.
There is, however, risk with selling options that needs to be controlled. If you sell a call, you have the responsibility to deliver the underlying stock if prices rise and the option is exercised. You can see this graphically in the chart below.
See below, if you had sold a call in April on Google (GOOG), with a strike price of $450 per share, and the stock gapped up (like it did later in the month, to $550), you are still responsible to deliver the stock to the options buyer for $450. That means you will lose $100 per share as you buy the stock on the open market for $550 to deliver it to your options buyer for $450.
The good news is that this risk can be controlled, and is partially offset by the premium you were initially paid. Once they are netted out, these losses may not be as much as you think. I am using an extreme example of a large gap to make the point that option selling does not need to be scary. In the video that accompanies this article, we will look at how this trade worked out.
In the next section of this lesson, we will discuss the covered call strategy to illustrate how you can further protect yourself from these disadvantages while still retaining the benefits of being an option writer.
Watch the video for more information:
By John Jagerson of LearningMarkets.com