Options trading can seem intimidating to newcomers. But with some education and some practice, it can be a profitable endeavour. In this article, we’ll discuss one of the most straightforward options strategies: call writing. We’ll define call writing and explain how it works, and we’ll also look at some scenarios in which this strategy might be advantageous. Read more about call writing below.
What is call writing in options trading?
Call writing is the process of selling call options on security. The seller or “writer” of the call option contract agrees to sell the underlying security to the buyer at a set price (the strike price) on or before a specific date (the expiration date).
In return for assuming this obligation, the writer receives a premium from the buyer. This premium is the option contract’s price and indicates the most significant loss the writer can incur. However, the writer keeps the entire premium if the stock price never reaches or exceeds the strike price before the expiration.
How does call writing work?
Let’s look at an example to understand how options strategies like call writing work. Suppose you own shares of ABC Corporation, which is currently trading at $50 per share. You believe the stock price will rise in the next few months, but you’re not sure how high it will go. You also don’t want to sell your shares because you think they’ll be worth even more in the future. So instead of selling, you write call options on ABC stock with a strike price of $55 and an expiration date of three months from now.
By writing these call options, you’re giving the buyer the right to purchase 100 shares of ABC stock from you for $55 per share at any time in the next three months. In return for this right, the buyer pays you a premium of $2 per share, or $200 total. It is the maximum amount that you can lose on the trade. If ABC stock never reaches or exceeds $55 during the three months, the call options will expire worthlessly, and you’ll keep the entire premium.
On the other hand, if ABC stock does rise above $55 at any point before expiration, the buyer has the right to purchase your shares for $55 each. Suppose ABC stock rises to $60 per share. The buyer exercises their option and purchases your 100 shares for $5,500.
You’ve still made a profit on the trade because you initially paid only $53 per share for the stock. However, if ABC stock rises to $65 per share, you would lose money on the trade. The buyer would exercise their option and purchase your shares for $6,500, but you initially paid $53 per share for the stock.
When might call writing be advantageous?
There are a few scenarios in which call writing might be advantageous.
- If you’re bullish on a stock but don’t want to sell it, writing call options is a way to generate income from your position.
- If you own a portfolio of stocks and want to hedge against a potential decline in the overall market, writing call options is one way to do this.
- If you’re trying to generate income from a stock that you believe will be range-bound for some time, writing call options can be an excellent way to do this.
Risks associated with call writing
There are a few risks to consider before writing call options.
- You could lose money on the trade if the stock price rises sharply. For example, you would lose money if you wrote call options with a strike price of $55 and ABC stock rose to $65 per share.
- If you write too many call options, you could own more shares than you originally intended. Suppose you write ten call option contracts, each for 100 shares of ABC stock.
- If the stock price rises above the strike price of all ten contracts, you would be obligated to sell 1,000 shares of ABC stock. It could significantly increase your risk exposure if the stock price falls sharply.
- Keep in mind that options are a waste asset. It means that they lose value over time. So if you’re writing call options with long-term expiration dates, you need to be aware of this.
Tips for successful call writing
To learn more about options trading and strategies like call writing, traders can attend seminars, take courses, or read more books or articles on the subject. It is also essential to have a broker or financial advisor who is knowledgeable about options trading and can provide guidance and support.
