Sell Call Option Strategy – How it Works and When it Works Best

 

What Does it Mean to Sell Call Options?

Call options are like any other stock, they have a value and can be purchased and sold at the market price.

But unlike stocks, did you know you can sell a call option even if you don’t own it?

Because options are just a contractual agreement between a buyer and a seller, you can choose to buy or sell them at any time.

In an exchange traded market, like options, you will always find a buyer or seller to transact with.

Market makers assume the intermediary role and take on the risk of “making the market”.

As a trader you can always sell call options, but when does it work best and how do you profit?

 

How Does a Sell Call Strategy Work?  (Option Refresher)

If you are selling a call option that you do not own, you are called a “naked short”.

Short sellers of call options have an obligation to sell their stock at the strike price to the buyer, before the expiry date.

Huh?

The call option allows the buyer to be able to buy a stock at a predetermined price before the expiry date.  For this privilege the buyer pays a premium.

On the flip-side, the seller of the call option has to sell their stocks to the buyer of the call option at the predetermined price before expiry.

Imagine a call option contract was written for a stock at $60 a share. Currently it trades for $50.

If the stock shoots up to $70 before the option contract expires, the buyer of the call option can make a profit.

The buyer exercises their right to buy the stock at the contractual agreed upon price for $60, and sells it at market for $70. Turning a profit of $10 per share.

But who loses in this example?

The seller of the call option contract.

This seller will need to sell their stock for the agreed upon $60 to the buyer, even though the market value is $70.

But what if the seller of the call option doesn’t own the shares?

They will be held responsible to deliver the shares or pay the difference – amassing enormous potential losses.

However, what if the seller of the call option actually owns the stock?

Then it becomes the favorite weekly income option strategy of investors!

Read on.

 

How to Build the Sell Call Option Strategy (Covered Call Strategy)

If you own a stock and want to sell call options against it, it becomes a covered call strategy.

The term covered indicates that you are covered by the fact you own shares against the calls you will sell.

This is one of the best weekly income strategies if you own stock.

Here is how the sell call option works, or the covered call strategy:

  1. You own a stock already, which has options listed (not all do, but most big companies do)
  2. Choose a level above which you believe stock won’t go by a certain date
  3. Sell call option at that level and expiry

The long stock and short call option will combine to create the covered call strategy.

Your profits are limited to the amount of premium you receive for selling the call option.

Losses are theoretically limited to the total loss of the stock.

Because you own the shares, this risk is already factored in as part of stock ownership.

 

Here is the hockey stick diagram of the covered call option strategy:

Covered Call Strategy Profit Loss Diagram (Sell Call Option)

 

 

Covered Call Strategy Example (Sell Call Option)

For this example we will use Microsoft stock.

I am going to assume an ownership of 100 Microsoft shares.  My outlook is a long term investor, holding this stock position for the foreseeable future.

I just want to use my stock position to earn an extra passive income.

Here is a chart of Microsoft, from a technical analysis perspective the stock has a resistance (ceiling) level at $97.50 per share.

If you want to learn more about support and resistance read this article here >

 

Microsoft Stock MSFT - Technical Analysis

Microsoft Stock MSFT – Technical Analysis

 

Looking at the chart, I think we will stay below $97.50 until the third week of June. This is when options expire, third Friday of each new month.

The June 15th, $97.50 call option is currently trading for $1.54 per options contract.

Each options contract is for 100 shares.

Therefore if I sell the call option above I will receive a total of $154 USD in my account – a passive profit if MSFT stock prices stay below $97.50 as anticipated.

 

Scenario #1 – Profitable Covered Call Strategy

If MSFT stays below $97.50 by June 15th, I will keep the $154 USD profit and retain ownership to my 100 MSFT shares.

This is the easy scenario, and if you are doing your technical analysis properly, the most likely scneario.

But what if Microsoft shares go above $97.50?

You get the second scenario below.

 

Scenario #2 – Losing Covered Call Strategy

If Microsoft goes above $97.50 you were wrong in your analysis.

However, your 100 shares that you own will be increasing in price.  Do you get to keep this profit?

Unfortunately not.

Because the call option buyer will have the “option” to buy your stocks for $97.50 before June 15th, 2018.  This is what you received the $154 USD for.

You have two options at this point:

  1. Buy back the call option you sold at a higher price before the expiry date, say $300 USD – which means you lose $146 ($300 – $154 premium collected)
  2. Hold everything until expiry, you will be exercised and you sell your 100 shares of MSFT at $97.50, and keep the $154 premium

While it sounds like option two is far scarier, what if you bought the shares at $50 a few months ago?

You realize the profit on expiry of the stock. You basically sell it at the $97.50 price, even though it’s trading higher.

At this point you can take the cash proceeds and buy Microsoft once again, and continue the covered call strategy.

This is the beauty of this strategy.

It is a way to create passive profits from stock you already own as an investor.

 

When to Avoid the Sell Call Option Strategy

If you own a stock and you believe it will continue to move higher in the near future, you want to avoid the covered call strategy.

This is because your profit on your long stock position is limited to the strike price you sold the call option at.

You will have to conduct accurate technical analysis, which is what we teach you in our Foundations Course here >

Anytime you expect a strong rally in the near future, or an increase of volatility the sell call option covered call strategy should be avoided.

One other aspect to consider is the behavior of the stock option.  Volatile stocks are more dangerous, but will pay you more premium for the sell call option.

Trend based stocks are more probable to pay you, but will pay you less premium as a result.

One last obvious time to avoid selling a call option is if you do not own the stock in your portfolio already.

Covered calls need to be covered, or can be very dangerous.

 

Can you Use the Sell Call Option Strategy on Every Stock?

In order to use the covered call strategy you will need to ensure that a stock is “optionable”.

This means that your stock of choice has options listed on an exchange.

Not all stocks do.

In fact, the smaller the company and cheaper the share price the less likely it is to have options.

Why not?

There has to be enough investor demand around the company shares in order to make an options market.

Basic business principles of supply and demand reign in options trading also.

 

Sell Call Option – Covered Call Option Strategy Conclusion

That’s it for today, you now understand one of the favorite passive income options strategies.

Covered call option strategies are used by major institutional investors.

Now you too can profit like the PROs.

 

If you want to join us in our live trading room, check out the Day Trader package here >

If you prefer to trade more passively, checkout our newsletter, trade ideas and live analysis in the Swing Trader package here >

 


The information contained in this post is solely for educational purposes, and does not constitute investment advice. The risk of trading in securities markets can be substantial. You should carefully consider if engaging in such activity is suitable to your own financial situation. TRADEPRO Academy is not responsible for any liabilities arising as a result of your market involvement or individual trade activities.