Short Calls

The investor who sells a Call option without owning either an equivalent number of shares in XYZ or another Call option has written an uncovered Call option.

This strategy offers limited profit potential while exposing the investor to what could be extremely large losses!

For this reason, writing uncovered Call options is unsuitable for all but the most experienced and deep-pocketed options professional!

Opinion: Bearish.

Example: Short 5 XYZ Oct 60 Calls.

Description: The investor writing Call options should firmly believe that XYZ is not going up! XYZ doesn’t have to go down, but it most definitely cannot go up. This is because the strategy’s break-even point at expiration is a certain distance above the then current stock price. Thus, depending on the option’s strike price, writing Call options can be a viewed as a neutral to bearish strategy.

Writing Calls: Why?

Writing uncovered (“naked”) Call options is a strategy with very high risk for a small potential return. Given this obvious imbalance, why would a prudent investor wishing to preserve and build his or her capital write Calls?

The key to the success of this strategy is to get to that point without having XYZ rally too far. If successful, profits will be small, given the risks. If XYZ “doesn’t go quietly,” one large up move could wipe out some, if not all, of the profits from may small wins!

A word of advice:

No matter how tempting it is, no matter how successful your friends have been, no matter how many months have passed with the at-the-money Call expiring worthless, no matter what,

DON’T DO IT!

For the average investor who’s regular day job does not involve the diligent monitoring of XYZ’s whereabouts, or for anyone wishing to get a restful nights sleep, this is sound advice!

Insurance Salesman: All too often, option critics are quick to point out how speculative, risky and unnecessary options are. What they often fail to point out is that options are, for the most part, designed to be an instrument for the transference of risk.

In the case of a Call writer, he or she is acting as an insurance salesman. For a small fee, the investor is willing to sell the Call buyer a policy, accept an unknown amount of risk, and hope that the word “takeover” is never heard!

Is there a short-seller in the house?

Writing Calls is not the same as a short sale of XYZ stock. If XYZ rallies above the strike price, the writer may still make a profit. To the downside, the short sale has much higher reward potential.

If XYZ rallies above the strike and the Call is assigned, the investor’s new position will be short XYZ stock. For most option investors, this is neither a familiar nor a comfortable position. It is, however, altogether very possible!

Selection: Month & Strike Price:

Although not recommended as a strategy, writing Calls is still one of the basic building blocks used in more complex strategies.

Trade-offs:

The selection process is full of choices. With four different expiration months and three, four, five or more different strike prices for each month, the investor is confronted with a long list of possible Call options to write.

Assuming that the previous advice was taken, most investor’s will be writing Calls as part of a more dynamic strategy. Thus, this review will focus on time decay along with strike price selection.

Purpose: Time Decay or Protection?

When constructing a position which involves writing Calls, the investor should focus on shat the Call sale is intended to accomplish.

An investor who has purchased ATM & OTM four to six month Calls might consider writing some near-term ATM or OTM Calls to offset the decay.

An investor wanting to protect his or her stocks and/or option position against losses should XYZ decline, would write ITM Calls.

ATM & OTM Calls: Time Decay.

If the Call is being written so that its time decay will be used to offset the time decay of various long Calls in the position, the investor should focus on the first two expiration months (near-term options 1 & 2) for a candidate to write.