Selling Index Calls Explained

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Selling Index Calls

The index short call strategy is a bearish strategy designed to earn from the premiums for selling the index call options with the hope that they expire worthless.

Index Short Call Construction
Sell 1 ATM Index Call

The options trader employing the index short call strategy expects the underlying index level to be below the call strike price on option expiration date.

Limited Profit Potential

Maximum profit is limited to the premiums received for selling the index calls.

The formula for calculating maximum profit is given below:

  • Max Profit = Premium Received – Commissions Paid
  • Max Profit Achieved When Index Settlement Value

Unlimited Risk

As the index level could rise dramatically, there is virtually no limit to the loss sustainable should the index level rallies explosively.

The formula for calculating loss is given below:

  • Maximum Loss = Unlimited
  • Loss Occurs When Index Settlement Value > Index Call Strike Price + Premium Received
  • Loss = Index Settlement Value – Index Call Strike Price – Premium Received + Commissions Paid

Breakeven Point(s)

The underlier price at which break-even is achieved for the index short call position can be calculated using the following formula.

  • Breakeven Point = Index Call Strike Price + Premium Received

Example

XYZ Index is a broad based index representative of the entire stock market and its value in June is 400. Believing that the broader market will fall moderately in the near future, an options trader sells a six-month XYZ index call with a strike price of $400 expiring in December for a quoted price of $4.50 per contract. With a contract multiplier of $100, the premiums received for selling the index call option comes to $450.

Suppose XYZ Index rose to 420 in December and the DEC 400 XYZ index call expires in-the-money. At settlement value of 420, the DEC 400 XYZ index call option will possess an intrinsic value of $20 and upon assignment of this option, the trader is required to pay a settlement amount of $2000 ($20 x $100 contract multiplier). Taking into account the premium received for selling the index call option, which is $450, the trader’s net loss comes to $1550.

Suppose XYZ Index went down to 380 in December and the DEC 400 XYZ index call expires out-of-the-money. At settlement value of 380, the DEC 400 XYZ index call option will expire worthless with zero intrinsic value. The trader’s net profit is therefore equal to the amount received for selling the index call option which is $450.

Commissions

For ease of understanding, the calculations depicted in the above examples did not take into account commission charges as they are relatively small amounts (typically around $10 to $20) and varies across option brokerages.

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However, for active traders, commissions can eat up a sizable portion of their profits in the long run. If you trade options actively, it is wise to look for a low commissions broker. Traders who trade large number of contracts in each trade should check out OptionsHouse.com as they offer a low fee of only $0.15 per contract (+$4.95 per trade).

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Writing Puts to Purchase Stocks

If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount. [Read on. ]

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Effect of Dividends on Option Pricing

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Bull Call Spread: An Alternative to the Covered Call

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Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date. [Read on. ]

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What is the Put Call Ratio and How to Use It

Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator. [Read on. ]

Understanding Put-Call Parity

Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. [Read on. ]

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Valuing Common Stock using Discounted Cash Flow Analysis

Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow. [Read on. ]

Selling Index Calls

Definition:
A put option is an option contract in which the holder (buyer) has the right (but not the obligation) to sell a specified quantity of a security at a specified price (strike price) within a fixed period of time (until its expiration).

For the writer (seller) of a put option, it represents an obligation to buy the underlying security at the strike price if the option is exercised. The put option writer is paid a premium for taking on the risk associated with the obligation.

For stock options, each contract covers 100 shares.

Buying Put Options

Put buying is the simplest way to trade put options. When the options trader is bearish on particular security, he can purchase put options to profit from a slide in asset price. The price of the asset must move significantly below the strike price of the put options before the option expiration date for this strategy to be profitable.

A Simplified Example

Suppose the stock of XYZ company is trading at $40. A put option contract with a strike price of $40 expiring in a month’s time is being priced at $2. You strongly believe that XYZ stock will drop sharply in the coming weeks after their earnings report. So you paid $200 to purchase a single $40 XYZ put option covering 100 shares.

Say you were spot on and the price of XYZ stock plunges to $30 after the company reported weak earnings and lowered its earnings guidance for the next quarter. With this crash in the underlying stock price, your put buying strategy will result in a profit of $800.

Let’s take a look at how we obtain this figure.

If you were to exercise your put option after earnings, you invoke your right to sell 100 shares of XYZ stock at $40 each. Although you don’t own any share of XYZ company at this time, you can easily go to the open market to buy 100 shares at only $30 a share and sell them immediately for $40 per share. This gives you a profit of $10 per share. Since each put option contract covers 100 shares, the total amount you will receive from the exercise is $1000. As you had paid $200 to purchase this put option, your net profit for the entire trade is $800.

This strategy of trading put option is known as the long put strategy. See our long put strategy article for a more detailed explanation as well as formulae for calculating maximum profit, maximum loss and breakeven points.

Protective Puts

Investors also buy put options when they wish to protect an existing long stock position. Put options employed in this manner are also known as protective puts. Entire portfolio of stocks can also be protected using index puts.

Selling Put Options

Instead of purchasing put options, one can also sell (write) them for a profit. Put option writers, also known as sellers, sell put options with the hope that they expire worthless so that they can pocket the premiums. Selling puts, or put writing, involves more risk but can be profitable if done properly.

Covered Puts

The written put option is covered if the put option writer is also short the obligated quantity of the underlying security. The covered put writing strategy is employed when the investor is bearish on the underlying.

Naked Puts

The short put is naked if the put option writer did not short the obligated quantity of the underlying security when the put option is sold. The naked put writing strategy is used when the investor is bullish on the underlying.

For the patient investor who is bullish on a particular company for the long haul, writing naked puts can also be a great strategy to acquire stocks at a discount.

Put Spreads

A put spread is an options strategy in which equal number of put option contracts are bought and sold simultaneously on the same underlying security but with different strike prices and/or expiration dates. Put spreads limit the option trader’s maximum loss at the expense of capping his potential profit at the same time.

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Writing Puts to Purchase Stocks

If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount. [Read on. ]

What are Binary Options and How to Trade Them?

Also known as digital options, binary options belong to a special class of exotic options in which the option trader speculate purely on the direction of the underlying within a relatively short period of time. [Read on. ]

Investing in Growth Stocks using LEAPS® options

If you are investing the Peter Lynch style, trying to predict the next multi-bagger, then you would want to find out more about LEAPS® and why I consider them to be a great option for investing in the next Microsoft®. [Read on. ]

Effect of Dividends on Option Pricing

Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date. [Read on. ]

Bull Call Spread: An Alternative to the Covered Call

As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. In place of holding the underlying stock in the covered call strategy, the alternative. [Read on. ]

Dividend Capture using Covered Calls

Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date. [Read on. ]

Leverage using Calls, Not Margin Calls

To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin. [Read on. ]

Day Trading using Options

Day trading options can be a successful, profitable strategy but there are a couple of things you need to know before you use start using options for day trading. [Read on. ]

What is the Put Call Ratio and How to Use It

Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator. [Read on. ]

Understanding Put-Call Parity

Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. [Read on. ]

Understanding the Greeks

In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as “the greeks”. [Read on. ]

Valuing Common Stock using Discounted Cash Flow Analysis

Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow. [Read on. ]

The Basics of Covered Calls

Professional market players write covered calls to increase investment income, but individual investors can also benefit from this conservative but effective option strategy by taking the time to learn how it works and when to use it. In this regard, let’s look at the covered call and examine ways it can lower portfolio risk and improve investment returns.

What Is a Covered Call?

You are entitled to several rights as a stock or futures contract owner, including the right to sell the security at any time for the market price. Covered call writing sells this right to someone else in exchange for cash, meaning the buyer of the option gets the right to own your security on or before the expiration date at a predetermined price called the strike price.

A call option is a contract that gives the buyer the legal right (but not the obligation) to buy 100 shares of the underlying stock or one futures contract at the strike price any time on or before expiration. If the seller of the call option also owns the underlying security, the option is considered “covered” because he or she can deliver the instrument without purchasing it on the open market at possibly unfavorable pricing.

Covered Call

Profiting from Covered Calls

The buyer pays the seller of the call option a premium to obtain the right to buy shares or contracts at a predetermined future price. The premium is a cash fee paid on the day the option is sold and is the seller’s money to keep, regardless of whether the option is exercised or not.

When to Sell a Covered Call

When you sell a covered call, you get paid in exchange for giving up a portion of future upside. For example, let’s assume you buy XYZ stock for $50 per share, believing it will rise to $60 within one year. You’re also willing to sell at $55 within six months, giving up further upside while taking a short-term profit. In this scenario, selling a covered call on the position might be an attractive strategy.

The stock’s option chain indicates that selling a $55 six-month call option will cost the buyer a $4 per share premium. You could sell that option against your shares, which you purchased at $50 and hope to sell at $60 within a year. Writing this covered call creates an obligation to sell the shares at $55 within six months if the underlying price reaches that level. You get to keep the $4 in premium plus the $55 from the share sale, for the grand total of $59, or an 18% return over six months.

On the other hand, you’ll incur a $10 loss on the original position if the stock falls to $40. However, you get to keep the $4 premium from the sale of the call option, lowering the total loss from $10 to $6 per share.

Bullish Scenario: Shares rise to $60 and the option is exercised
January 1 Buy XYZ shares at $50
January 1 Sell XYZ call option for $4 – expires on June 30, exercisable at $55
June 30 Stock closes at $60 – option is exercised because it is above $55 and you receive $55 for your shares.
July 1 PROFIT: $5 capital gain + $4 premium collected from sale of the option = $9 per share or 18%
Bearish Scenario: Shares drop to $40 and the option is not exercised
January 1 Buy XYZ shares at $50
January 1 Sell XYZ call option for $4 – expires on June 30, exercisable at $55
June 30 Stock closes at $40 – option is not exercised and it expires worthless because stock is below strike price. (the option buyer has no incentive to pay $55/share when he or she can purchase the stock at $40)
July 1 LOSS: $10 share loss – $4 premium collected from sale of the option = $6 or -12%.

Advantages of Covered Calls

Selling covered call options can help offset downside risk or add to upside return, taking the cash premium in exchange for future upside beyond the strike price plus premium.during the contract period. In other words, if XYZ stock in the example closes above $59, the seller makes less money than if he or she simply held the stock. However, if the stock ends the six-month period below $59 per share, the seller makes more money or loses less money than if the options sale hadn’t taken place.

Risks of Covered Calls

Call sellers have to hold onto underlying shares or contracts or they’ll be holding naked calls, which have theoretically unlimited loss potential if the underlying security rises. Therefore, sellers need to buy back options positions before expiration if they want to sell shares or contracts, increasing transaction costs while lowering net gains or increasing net losses.

The Bottom Line

Use covered calls to decrease the cost basis or to gain income from shares or futures contracts, adding a profit generator to stock or contract ownership.

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