- April 16, 2018
- Posted by: fortunatetrader
- Category: Trading 101
What is a Call option and a Put option and how does it work? — Part3 – SELLING a CALL
Make sure you understand what the options are first: What is an Option?
Welcome to the third article of the series.
We have learned in the last two articles how to BUY a CALL and a PUT
What is a Call option and a Put option and how does it work? – Part1 – Buying a CALL
What is a Call option and a Put option and how does it work? – Part2 – Buying a PUT
There are two different kinds of options: CALLs and PUTs.
And we can either BUY or SELL them
The four possible actions to do with options:
-BUY a CALL
-BUY a PUT
-SELL a CALL
-SELL a PUT
When you buy an option you have the right to buy or sell the stock (or underlying) when you want during a define period.
But why would I want to SELL a CALL?
What is selling a CALL option?
Selling a CALL option is having the OBLIGATION to SELL something to someone at a defined price during a specific amount of time in exchange of a premium.
As a seller of a CALL you expect the underlying asset to drop below the defined price before the expiration date.
Let’s use a real life analogy. You know that I love my “house” example.
Same scenario here but switch roles from the first article. Instead of being the buyer, I already own the house and I’m willing to sell it. For this article I will explain a Covered CALL; covered, because you own the underlying and let’s say that you have bought it in the past for the same price of the actual market price of $100 000.
You decide to sell a contract in the open market looking for a buyer.
You are telling to the potential buyers: “Hey, I’m ok reserving for you the right to buy my house in the next year for the actual market price of $100 000. Let’s write that down in a contract. And in exchange for my OBLIGATION to sell it to you, you will have to give me $1 000 right now.”
This is a fee not a down payment.
It seems fair that you sign a contract that will give you the OBLIGATION to SELL in exchange of a certain amount of money since you are taking your house off the market for a year and you might have received a better offer during that time.
Well, my friend, you just SOLD A CALL option.
Let’s say that in one year the real estate market plunges.
The house value in the market is now $60 000.
Do you think the buyer of the CALL option will exercise their RIGHT to buy your house?
I don’t think so.
If it’s still ambiguous to understand the process please revisit Part1 and Part2 of this series, we really want you to assimilate 100% of it.
Why won’t the buyer exercise his RIGHT and forces you to SELL your house at a price of $100 000?
It’s plain and simple. It’s because he can buy it right now in the market at a price of $60 000. Why should he pay $40K more?
On your end you are “stuck” with your house. But, hey! You don’t really mind, you received $1 000 to live in it for another year. It’s still a good deal.
That is selling a CALL option.
In general, it’s because you think that the market will go down; that the market will be bearish and you will keep the premium.
“But what if the house market went up, increasing the price of this house to $120 000 instead of going down?”
If that occurs, you would probably have been CALLED away. The buyer might have exercised his RIGHT.
Because he can force you, because of the contract you signed, to sell your house at the concluded price of $100 000 when right now, he can sell it to the market at $120 000.
You can’t cancel the transaction since you have committed to it by receiving the initial $1 000.
You would have lost a potential profit of $20 000 if you had just kept the house but you did make $1 000 just for offering your house at a selling price that you were comfortable with.
Today we have learned about one of the four ways of trading options: selling a CALL option.
In short, a CALL option is called a “CALL” because the owner has the right to “call the stock away” from the seller. It is also called an option because the owner of the contract has the RIGHT, but not the OBLIGATION, to BUY the stock at the strike price. In other words, the owner does not have to exercise the option and buy the stock. If buying the stock at the defined price is unprofitable for him, the owner of the CALL can just wait the predetermined timeframe and let the option expire. But if is a case where the buyer sees an opportunity of profitability, he can oblige the seller to SELL at the defined price. In this case the seller of the CALL will be assigned the shares.
– Make It Happen –