Call option selling explained with a house example.
Explanation of selling a call option, aka call writing, ends up being confusing and filled with jargon. It is an easy and powerful concept if understood correctly.
We are going to explain selling a call options using the housing market and our view of whether property/house prices will increase or decrease. We will go on to explore the different outcomes and risks of selling a call option.
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- Techcial explanation of selling/writing call options, as per Investopedia
- Simplified explanation of writing/selling Call option
- Relate Simplified terms to technical terms of selling Call option
- Difference between selling American and European Call Option
- Profit Loss – Selling/Writing a Call Option
- Profit Loss – Selling Calls – Specific cases for American options
- Maximum Profit – Selling/Writing a Call Option
- Maximum Loss – Selling/Writing a Call Option
- Risks of Selling/Writing Call Options
- Benefits of Selling/Writing Call Option
- Conclusion of Selling/Writing Calls
Technical explanation of Selling/writing Call Option:
(We will simplify it right after this)
Call option writing is a theoretically unlimited loss potential trade, if no hedging is done. The call writer takes on the obligation of delivering shares at a fixed price during the length of the agreed time-period if the buyer of the call exercise’s the call. To take on this obligation/risk, the call writer/seller takes an up-front premium.
Simplifying the Call Writing/Selling definition:
We will use the housing market as a way to explain selling a call option.
First off, writing an option is simply selling an option. There are reasons for calling it “writing” but for most intents and purposes “selling” can be used.
Current house prices in a particular area are 1,000 per house.
The prices have been going up for the last few months.
Due to prices going up over the past few months, a lot of people want to buy the house and believe the prices will go up to 1200 in the next 30 days.
Your opinion about the house prices is: prices have gone up a lot already, in the next 30 days price will either not go up or go up to a maximum of 1,100.
You are a savvy property trader and are open to take risk based on your opinion that house prices in the next 30 days will go to a maximum of 1,100.
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You approach one of the many people who think price will go to 1,200 in the next 30 days. Let’s call the person: Mr. B
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You offer to sell Mr. B the house for 1,100 in the next 30 days provided he pays you 25 today.
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Mr. B agrees to your offer and pays you: 25.
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Mr. B can decide at the end of 30 days, incase of european options, to buy the house at 1,100 or not.
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Mr. B can decide at anytime during the 30 days, incase of american options, to buy the house at 1,100 or not.
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Why would they agree to this offer? They might not have 1,100 today. They might not want to take risk of 1,100. Various other reasons.
This agreement of a price and timeframe in which you have to sell the house to Mr. B is called selling a call option.
Mr. B can chose not to buy the house during/after this period, but if he decides to buy the house you have to give him the house at the agreed price.
Region specific note: The contract can be that you will pay Mr. B the difference in price or deliver the house.
Convert terms used in the example to technical terms:
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Main difference between selling/writing American options and European options is:
Using our example above:
If the agreement between Mr. B and you allows Mr. B to buy the house at the agreed price(1,100) at any time during the 30 days, then it is called an American option.
If the agreement between Mr. B and you allows Mr. B to buy the house at the agreed price(1,100) only at end of 30 day period, then it is called a European option.
Profit-Loss Situations of Selling Calls
(Month End) |
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Price of house at the end of 30 days. |
Amount you received from Mr. B for giving him the choice to buy house at 1,100 at the end of 30 days. |
Price Mr. B can “choose” to buy the house at from you. |
The price is less than 1,100. Mr. B tells you to keep the premium as he can buy the house from the market at a lesser price. Premium received = 25 |
(Month End) |
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Price of house at the end of 30 days. |
Amount you received from Mr. B for giving him the choice to buy house at 1,100 at the end of 30 days. |
Price Mr. B can “choose” to buy the house at from you. |
You keep the premium. Premium paid = 25 The price is above 1,100. Mr. B decides to buy the house at 1,100 from you. You don’t have the house so you buy the house from the market at the current price: 1150 Profit/Loss = Sell Price – Buy Price + Premium Received: 1,100 – 1,150 + 25 = -25 |
Specific cases for American Options
Mr. B decides to buy the house at agreed price sometime during the month, let’s assume mid way through the month.
(mid-way through the month) |
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Price of house 15 days into the agreed 30 day period. |
Amount you received from Mr. B for giving him the choice to buy house at 1,100 at the end of 30 days. |
Price Mr. B can “choose” to buy the house at from you. |
The price is below 1,100 but there is news of a possible dividend(or other such). Mr. B asks for the shares to be delivered so that Mr. B is sure to get the dividend/other. Sell Price(Agreed price) – Purchase Price(Market Price) + Premium received = 1,100 – 1,090 + 25 = +35 |
(mid-way through the month) |
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Price of house 15 days into the agreed 30 day period. |
Amount you received from Mr. B for giving him the choice to buy house at 1,100 at the end of 30 days. |
Price Mr. B can “choose” to buy the house at from you. |
The price is above 1,100 and there is news of a possible dividend(or other such). Mr. B asks for the shares to be delivered so that Mr. B is sure to get the dividend/other. He doesn’t have to give a reason. Sell Price(Agreed price) – Purchase Price(Market Price) + Premium received = 1,100 – 1,200 + 25 = -75 |
Note: There can be very high penalties charged for short-delivery i.e. you don’t have the house or are unable to buy the house in the example. Please read and understand exchange specific rules and penalties before selling an option.
Maximum profit when selling Calls
General:
The maximum profit when writing/selling a call is limited to the premium taken.
This will happen when the stock(house in our example) price remains below the strike price(The price that Mr. B has a choice to buy at i.e. 1,100).
Special case:
If buyer of call option decides to take delivery of the stock(aka excercise) the call option while stock price is below strike price. Then the profit we make will increase, it will be:
Strike – Market stock price + premium received
See this table for an example: Strange profit This is a rare occurrence.
Maximum profit when selling Calls
In general:
The maximum loss when writing/selling a call is ,theoretically, unlimited.
This will happen when the stock(house in our example) price goes above the strike price plus premium taken i.e. 1,100 + 25 in our example.
American Options:
If the stock price starts moving up quickly or one of the many factors which help determine price of an option spurt the price of the call option up. There exists the possibility that buyer of call option might take delivery of the stock(aka excercise the call option).
The threat that the call buyer might ask for delivery can lead to panicking and closing the call option or holding on to the call option without the capital required to purchase the stock in the hopes of price dropping.
Both actions here are highly risk-management and expertise based and is a major pitfall of selling options without a hedge, selling a call option without the owning the underlying stock is called a naked call.
Covered calls are much safer i.e. you own the stock and sell a call, read concept explainer.
If you would still like to do a covered call but don’t own shares try: poor man’s covered call, read the concept
Risks of Selling Calls
Potential unlimited Loss, if unhedged:
The maximum profit when selling calls is the premium received.
The loss can potentially be unlimited, a stock price can move up a lot in 30 days or other agreed time-period.
As soon as price of stock is above Strike Price(Agreed price in example) + Premium received you start loosing money.
Covered calls, credit spreads etc are limited risk strategies and are preferred over naked calls . I repeat, selling call options without hedge has potential for unlimited losses.
Limited profit:
The maximum profit to be made by selling a call is the premium. While this may be a good profit, it might hamper your ability to take on other more profitable trades as margin will be blocked.
Leverage
Leverage can lead to impressive gains and unimaginable losses.
When selling an option, the exchange and broker block margin from your account. You might be trading a 1000 worth of underlying(stock/bonds/anything) and the broker blocks 100 from your account, while you have 2000 in your account. You write more call options.
More = 20.
Success! you made profit on all of them. Now your confidence to do this again is high.
Here is an exercise:
calculate your loss if in 1 month all 20 of them make a loss. Comment the percentage which would blow your account.
You should do this exercise with a pen and paper, it will stay in your brain.
To sum it up, leverage is good when used correctly but it should be used only after understanding it properly.
Infact if you are starting out, just don’t use leverage.
Overnight Risk:
You wrote a call(aka sold a call), the call price dropped and you are looking at a healthy profit. You decide to carry the position to the next day.
Suddenly middle of the night Mr. Elon Musk decides to tweet:
“Am considering taking Tesla private at $420. Funding secured.”
The stock opens higher by 20-30% and your call is now making a huge loss.
The tweet was just an example of what is possible overnight.
Overtrading:
You wrote a call, call price jumped up and you think surely the stock/call price can’t go much higher, you wrote another call with higher strike price.
Once again the call/stock price went up, now it definitely can’t go higher it is at resistance, another call written.
The cycle can keep going. Sooner or later, if the price keeps going up you will reach the point where you can’t keep writing calls and margin calls can happen.
No Off Days
The market doesn’t care about you having a migraine, fever, cold or a flat tyre. No matter what life throws at you when the market is open, your call price can/will change. So don’t plan on an off day on a market day and always have backups/fallbacks.
Expiry Risk – region specific
In some exchanges, such as US exchanges, the market is open beyond the closing bell called After market hours trading.
Using the example:
It is the 30th day of the month, last day of the agreement where Mr. B can ask you for the house at 1,100, the agreement ends at 3 PM but a fine print specifies that Mr. B can inform you by 5 PM if he wants the house.
The price of houses at 3 PM is 1,050 you are getting the maximum profit.
At 3:30 PM a big real estate developer announces we are doing a project in the area where the house is and will buy all houses that want to sell at 1,250.
Mr. B uses the fine print and asks you for the house at 1,100. Now you are in a loss situation because you will have to buy the house from the market at 1,250.
Possible penalties – region specific
If you don’t own the stock or are unable to buy the required stock to give delivery, if you are asked to give delivery, then there can be severe penalties. Check the contract specifications and penalties clause on the exchanges.
Benefits of Selling Calls
Once that we understand the profit loss of call selling/writing, let us understand the benefits:
If you understand various factors involved in option pricing calls can present a good opportunity to make profits. CME data suggests more than 70 percent call options expire worthless i.e. writer/seller makes a profit. Read the excellent article on investopedia
If call buyer is wrong on one point out of three you, call seller/writer, make a profit:
- direction of price,
- extent of price movement,
- timing of the move in price.
This being said, selecting the strike price, premium you should take etc are a very difficult set of parameters to get right if you are just starting out.
Selling calls without hedging, or owning underlying stock/bond/other, requires in-depth level of understanding of all factors affecting option prices, perfect risk-management. Even with all of these in places there will be times of losses, but if risk-management is strong-enough then the loss can be handled.
Selling Calls Conclusion
Selling call options, without owning the underlying or hedging, is an unlimited loss trade with a capped maximum profit. It is an advanced options trade which requires expert level understanding of factors affecting option prices and risk-management.
Call option buying explained with house as an example. Click here
See all our option concept explainers, click here.
Covered calls, to earn rent on stocks you own. Click here
Don’t have enough money to do a covered call, read about poor man’s covered call. Click here
All information here is for educational/research purposes only, we do not recommend trading.