Friday, July 16, 2010

Don't Be Afraid of Options - Part 3: Selling Call Options

As we discussed in our last post, we know that the value of an option decreases as time passes.  There is a way to profit from this phenomenon: we sell the option!  Before we get right into the nitty gritty options selling, let's dissect the behaviour of an option using a graph.

Graphing the Behaviour of an Option
If you surf websites that talk about options, chances are you'll see a graph similar to the one below.  Don't be afraid of graphs!  They give us a lot of information in a very compact format.  Going back to the figure below, you will see a typical line graph.  On the vertical axis, we have plotted the gain.  This is how much money you will be making (or losing).  On the horizontal axis, you have the stock price.  The blue line is what the gain is at each stock price.

In the first post of this series, we talked about buying a call option.  The graph below shows how much money you would make if you had bought 1 contract of a $55 call option of WMT when the share price was at $50.  We are looking at the gain at the time when the option expires.  I have assigned a cost of the option at $2.50/share.  So, doing the math, we figure that we would have paid $250 for the option ($2.50/share x 100 shares/contract).  If the share price were to rise to $62 at expiry, the call option would be worth $7/share (you have the right to buy a $62 share at $55, so $62-55 = $7).  So, you would have a cool $700 in your pocket.  Since you paid $250 initially, your gain would be $700 - $250 = $450.  Looking at the graph, find $62 on the horizontal axis, go up until you hit the blue line, go back to the left...and there, it's at $450.

Say you weren't as lucky and WMT's share price rose, but to $53 only.  At expiry, you still have the right to buy the shares at $55, but you really wouldn't want to because you could just as easily bought it for $53 on the open market.  So, your option is useless and is worth a big fat 0!  Since you paid $250 initially, and the option is worth $0, you gained a negative $250.  This is exactly what the graph tells you as well.

So, what's that yellow vertical's just a reminder of what the share price was when you purchased your option.  It really doesn't do anything.  So, there you have it, a graph of the behaviour of buying a call option.  You essentially lose money unless the WMT rises to $57.5 or above.  At that point, your gain is highly leveraged.  If you are not that lucky, and WMT rises only a little or even falls, then the most you can lose is $250.

Buying a Call Option

Writing (Selling) Call Options
Before I begin talking about selling options, let me tell you a little story about my misconception about options.  When I was first introduced to options, I thought that there was a company (probably the same company of the underlying stock, Walmart in this case) that issued all of the options for investors to buy and sell.  When I logged onto my brokerage account to buy an option, I thought that option originated from that particular company.  That notion is actually false.  Options exist because someone else wants to sell that particular option.  The Chicago Board Options Exchange (CBOE) simply gives the various options a symbol and acts as an exchange in which these transactions occur.  An investor (or hedge fund manager, etc.) actually has to write (sell) an option in order for it to exist.  Underlying companies do occasionally issue instruments similar to options, but they are called warrants.  Warrants typically have long expiry dates.

Let's now look at selling a call option.  What actually happens?  You or any other investor is able to sell an option as long as it is listed on the CBOE (or whichever options exchange at your location).  Recall that an option gives the owner the right to buy a stock at a certain price before a certain date.  So, when you sell an option, you are actually giving that right to someone else.  If instead of buying the call option we discussed above, you sold it, the person who bought that from you now has the same right to buy WMT at $55 before the expiry of the option.  By selling that option, you have to guarantee that right!

So, if you didn't own any WMT stock and you sold that call option, your gain would be as illustrated in the graph below.  First, when you sold that option at $2.50/share, the buyer pays you $250 up front.  Yay, free money!  Not so quick!  If WMT fails to rise above $55, then you're in luck.  The option is worthless and you've made $250.  What happens if WMT rises to $62?  At any time the option becomes in-the-money, the owner of the option can exercise it.  That means you would need to sell him that WMT option at $55/share.  So, if WMT rises to $62 at expiry, the broker of the owner of the option automatically exercises it for him.  You are on the hook to provide 100 shares of WMT at $55/share.  Now, since you don't actually own any shares of WMT, you have to buy them from the open market at $62/share and sell them to the option owner at $55/share.  Effectively, you have lost $7/share or $700...taking into account he paid you $250 initially for that option, you would have lost $450.

If you were really unlucky and Target goes bankrupt, driving all business to Walmart, and Walmart's stock rises to $90, you would lose $35/share ($90-$55) or $3500.  Taking into account the initial $250, your total loss would be $3250.  Now, for $250, is that really worth it?  Why would anyone sell a call option?  You are absolutely right!  Not many people would.  When you sell a call option without actually owning any shares of the underlying stock, it is called a naked call, probably named so because you're exposed to huge losses!  You have limited gain and unlimited loss.  Chances are your broker would not allow you to sell a naked call unless you have a margin account and can cover the potential losses.

Naked Call

When to Sell a Call Option
It would be quite ironic for me to end the discussion without actually telling you when we should sell a call option.  Of course, I wouldn't do that to you!  One of the strategies that I like is a covered call.  As you might guess, you have less exposure than you would if you initiated a naked call.  Essentially you would sell a call option and also own the same number of shares that would cover the call options.

Going back to our example above, instead of not owning any shares of WMT, we would actually own 100 shares of WMT.  Let's say you bought them at the same time when you sold your call option.  So, you paid $50/share for WMT.  Right away, you are up $250 by selling the call option.  If the share price rises above $55 and the buyer exercises his option, you would need to hand over the 100 shares that you have at $55/share.  The important thing to remember is that he still has to pay you the amount at the strike price, namely $55/share.  Since you bought the shares at $50/share, you would make $5/share or $500.  Add that to the initial $250 and you would have made $750.

If WMT rises to $53 and the option expires, you don't need to do anything!  The option is worthless and therefore it would be stupid for the buyer to exercise the option.  You keep the $250 and the stock actually rose $3/share or $300 over 100 shares.  So, you actually made $250 more than you would have if you had just kept the shares and not sold the option.

Covered Call

What essentially happens is that if the share price rises but not above the strike price, you get to keep all of the upfront fees that the buyer paid you.  If the share price rises above the strike price, your gains get capped at that price + the initial payment you received.

Therefore, covered calls reduces the risk of your investment, however, at the expense of the gains that you would have made if the share price really skyrocketed.  So, go on now and tell all your friends who invest that options can actually reduce the risk of your investment...they'd be shocked!

More to Come
Options is really a game changer in the world of investing.  As you saw above, a simple call option gives so many new possibilities.  And we haven't even touched put options yet!  We shall continue to explore the world of options in our upcoming posts.