Where stocks trade within a flat range, you can utilise call options to earn income. You do this by writing (selling) the calls over stock you hold, in turn receiving the option premium from the option taker.
You may write the call as either covered, or uncovered. In the case of the former, you hold the shares and use them as collateral with the exchange overseeing the contract, so you can deliver them if the option is exercised. When your shares are used as collateral, they earn dividends but cannot be sold.
Beyond income, writing calls offers some insurance against a falling share price. The increasing option premium mitigates your share losses. You can also lock in a higher sell price.
Should the option not be exercised before expiry, then it will expire worthless if the share price is below the exercise price. However, not only do you get to keep the shares but there is a premium which offsets the decline in value of the shares. Conversely, if the share price is above the exercise price, the option will be exercised, requiring you to sell the shares but again retain the premium.
Benefits of writing calls
Writing calls provides a source of income in a flat market. Unlike other options strategies, you may benefit from time decay and reducing volatility. The best outcome is for the stock to expire at the exercise price, holding its value. The option would expire worthless to the holder when you in fact sold it at a much higher price. Alternatively, you could buy back the option at a lower price, and profit on that difference while also forgoing the need to sell your shares.
Whereas the value of your shares might reduce if they are priced below the exercise price of the call, you profit from the reduction in the price of the premium. This provides some protection against a falling share price. Calls can also be written to secure the writer a more favourable selling price, should you have little desire to hold the shares.
Net profit consists of profit or loss on the shares, plus profit or loss on the option. Therefore, start by calculating the variance between the share price at expiry and when the call was written, before adding the difference between the premium received for the call and its intrinsic value.
Losses are limited to the initial share price at the time the option was written, less the option premium you receive
Profits are capped by the option premium you receive, plus the difference between the exercise price and the initial share price at the time the option was written
Breakeven is the initial share price when the option was written, less the premium you receive
Risks of writing calls
There are several risks when writing calls, including:
Exercise by the option taker - when the share price exceeds the exercise price, the option taker may exercise the option before expiry when going ex-dividend, however there is little you can do other than buy the call to close your position
Major falls in the share price - if you have covered the call you write, then you will fare better than if it were uncovered, however compared with buying a put there is still only a modest degree of protection to the downside when share prices fall
Major gains in the share price - although you won’t be exposed to direct financial losses, gains are limited since the exercise price caps your sales price to less than that available on the market
Choosing which call to write
In the event you write a call, you will choose the expiry date and exercise price. Again, you would only employ this option strategy if your asset outlook is neutral. When deciding, consider these aspects:
Lower exercise price (in the money) - you receive a larger option premium, which acts as greater protection against a share price drop. However, your final sale price is lower if the option is exercised. Option exercise is more likely if already in the money, meaning you deliver the shares.
Higher exercise price (out of the money) - you receive a smaller option premium, so there is less protection against a share price drop. However, your final sale price increases if the option is exercised. Since out of the money, it is least likely to be exercised and delivers the least income.
Modest exercise price (at the money) - best profits in a flat market due to time value, with modest downside protection and a modest final sale price if the option is exercised.
As with other options, longer terms provide higher income (premium) but more exposure to risk.
Closing out a written call
Most calls are exercised at expiry, it at all. However, the option taker has the right to do so beforehand when it is in the money and approaching ex-dividend. From the writer’s perspective, if the share price looks bullish you can buy back the call before expiry, provided the taker has not exercised it. Even if you make a loss on the premium, you get full exposure to the share price appreciating without being capped. If you wait too long, you risk the option being exercised, and you won’t be able to retain the shares.
Should the call expire worthless - that is, the share price does not finish above exercise price - you profit from the full premium. If at expiry the share price is above the exercise price, the call will be exercised and you must deliver the shares for the set price, regardless of the market price. Closing out your position beforehand prevents the possibility of the option taker exercising it.
There is also the choice to roll over a written call if you have a neutral view for the underlying stock. Like other instances of roll-over, you exit the existing position by buying back the call for the prevailing premium, and write (sell) a new call with a longer expiry and higher exercise price. The risks are that you again face the prospect of the taker exercising the option, and also limit your profit upside. It does however, defer immediate risk of exercise, while providing extra income (higher premium).
Writing calls leverages a flat or neutral outlook over a share by providing income (premium)
The call may be written uncovered or covered (shares used as collateral for delivery)
Writing a call partially protects against a falling share price, plus locks in a sell price
Risks associated with writing calls includes major falls or gains in the share price, and exercise by the option taker, which mostly happens at expiry but can happen beforehand (ex-dividend)
Losses are limited and profits are capped under a written call
Breakeven is the share price when the option was written, less the premium you receive
In the money positions with a lower exercise price provide you with a larger premium and more protection to price drops, but lower your final sale price and expose you to exercise risk
Out of the money positions with a higher exercise price provide you with a smaller premium and less protection to price drops, but increase your final sale price and lower exercise risk
At the money positions provide the best profits in a flat market
A call that expires worthless provides you the full premium, but if the taker exercises it while in the money, you must deliver the shares at the exercise price below that on market
You can buy back the call before expiry if not yet exercised, preserving ownership of your shares and allowing exposure to bullish price movements without being capped
Rolling over a written call is useful if you have a neutral view of the stock and want to earn extra income, but upside profits will remain limited and exercise risk remains