How to Sell Call Options to Generate Income

Selling call options is a strategy that can generate income for investors, particularly when they own the underlying asset. This approach involves a contractual agreement where the seller grants the buyer the right to purchase a specific asset at a predetermined price within a certain timeframe. This strategy can enhance returns on existing investments, especially when significant upward price movements are not anticipated for the underlying asset. The income comes from the premium received by the seller, boosting portfolio cash flow.

Understanding Call Option Basics

A call option represents a contract that gives its buyer the right, but not the obligation, to purchase an underlying asset, such as a stock or exchange-traded fund (ETF), at a specified price. This predetermined price is known as the strike price, and the transaction must occur on or before a set expiration date. When an investor sells a call option, they are referred to as the “writer,” and they receive an upfront payment from the buyer, which is called the premium.

Selling to open, or “writing,” a call option means the seller creates a new contract and takes on an obligation. If the option buyer chooses to exercise their right, the seller is then obligated to deliver 100 shares of the underlying asset per contract at the agreed-upon strike price.

There are two main types of call option selling strategies: covered calls and naked calls. A covered call involves the seller owning the corresponding number of shares of the underlying asset for each option contract sold. In contrast, a naked call involves selling an option without owning the underlying asset, exposing the seller to potentially unlimited risk if the asset’s price rises significantly. This article primarily focuses on covered calls due to their lower risk profile for many investors.

Account and Approval Requirements

Before engaging in options trading, including selling call options, investors must establish a standard investment account with a brokerage firm. These accounts can be either cash accounts or margin accounts. Many brokerages require that the underlying shares used to cover the call be held in a margin-enabled account to collateralize the obligation.

Brokerage firms require specific approval levels for options trading due to the risks involved. The process involves an application where investors provide information about their investment experience, financial situation, and risk tolerance. Selling covered calls usually falls under a lower approval level, often designated as Level 1 or Level 2, because the risk is limited by the ownership of the underlying shares. Higher approval levels are generally required for more complex or riskier strategies, such as selling naked calls.

Placing a Sell Call Option Order

Once a brokerage account is established and options trading approval is granted, initiating a sell call option trade involves several steps on a typical trading platform. First, an investor logs into their brokerage account and navigates to the options trading interface or the options chain for the specific underlying asset they wish to trade. This interface displays various option contracts available for that asset.

Next, the investor selects the desired expiration date for the option contract. Options contracts have varying maturities, ranging from a few days to several months or even years. Following this, the investor chooses the appropriate strike price, which is the price at which the underlying asset can be bought or sold if the option is exercised. The selection of both expiration date and strike price is a strategic decision influencing the premium received and the likelihood of assignment.

To sell a call option, select “Sell to Open” as the action. This indicates that the investor is initiating a new short option position, creating a new contract rather than closing an existing one. Specify the number of contracts to sell.

Finally, select the order type; a limit order is recommended for options trading. A limit order allows the investor to specify the exact price, or premium, they are willing to receive for selling the option. Unlike a market order, which executes at the best available price, a limit order provides price control, ensuring the trade occurs only at the specified premium or better. Before confirming and placing the trade, the investor should review all order details, including the premium to be received and any associated commissions or fees, which typically range from $0.65 to $1.00 per contract.

Managing Your Sold Options

After selling a call option, the investor must monitor the position as it approaches its expiration date. At expiration, there are generally three potential outcomes for a sold call option, depending on the relationship between the underlying asset’s price and the option’s strike price.

If the underlying asset’s price is below the strike price, the option is considered out-of-the-money (OTM) and will expire worthless. In this scenario, the seller keeps the entire premium received, and the obligation simply ceases to exist.

Conversely, if the underlying asset’s price is above the strike price, the option is in-the-money (ITM) and is likely to be assigned. Assignment means the seller is obligated to fulfill the contract by selling their 100 shares per contract at the strike price to the option buyer. This can occur at any time for American-style options or at expiration for European-style options. If the underlying asset’s price is equal to or very close to the strike price, the option is at-the-money (ATM), and assignment is uncertain, depending on minor price movements.

An investor can proactively manage a sold option position before expiration by executing a “buy to close” order. This involves buying back the exact same option contract that was initially sold, effectively neutralizing the obligation.

Investors might choose to buy to close to lock in profits if the option’s value has decreased, to reduce risk if the underlying asset’s price is moving unfavorably, or to free up the capital tied to the position. This action allows the seller to exit the trade on their terms rather than waiting for potential assignment or expiration.