What Happens When You Sell a Call Option?

Selling a call option is a financial transaction used by investors to generate income or manage existing equity positions. Understanding the mechanics and potential outcomes is important.

Understanding Call Options and Selling Them

A call option is a financial contract granting the buyer the right, but not the obligation, to purchase an underlying asset, such as a stock, at a predetermined price, known as the “strike price,” on or before a specified “expiration date.” Buyers typically acquire call options with the expectation that the underlying asset’s price will increase significantly. This allows them to profit by acquiring the asset at the lower strike price and then selling it at the higher market value, or by selling the option contract itself for a profit.

Conversely, selling, or “writing,” a call option means taking on the obligation to sell the underlying asset at the strike price if the option buyer chooses to exercise their right. The seller receives a payment, called a “premium,” from the buyer for taking on this obligation. The seller’s hope is often that the underlying asset’s price will not rise above the strike price, causing the option to expire worthless, allowing the seller to retain the entire premium as profit.

Initial Financials and Obligations

Upon selling a call option, the seller immediately receives the premium, which is deposited into their brokerage account. This premium represents the maximum profit achievable from the transaction if the option is not exercised. The Internal Revenue Service (IRS) generally treats premiums received from selling options as short-term capital gains, regardless of how long the position remains open, meaning they are typically taxed at ordinary income rates.

Selling a call option creates a binding obligation for the seller to deliver the specified number of shares of the underlying asset at the strike price if the option is exercised. This obligation carries different risk profiles depending on whether the call is “covered” or “naked.” A covered call involves the seller already owning the underlying shares, usually 100 shares for each option contract sold, which serves as collateral for the potential obligation. This significantly limits the seller’s risk because they already possess the shares required for delivery.

In contrast, a naked call means the seller does not own the underlying shares when the option is sold. This strategy carries substantially higher, theoretically unlimited, risk because the seller would need to purchase the shares at the current market price to fulfill the obligation if the option is exercised. Due to this heightened risk, selling naked calls typically requires a margin account with significant collateral, often requiring an account equity of tens of thousands of dollars, and specific authorization from a brokerage firm.

Scenarios After Selling a Call

After a call option is sold, its outcome largely depends on the movement of the underlying stock’s price relative to the strike price as the expiration date approaches. There are three primary scenarios that can unfold.

Option Expires Worthless

In the first scenario, if the stock price remains below the strike price at expiration, the call option expires “out-of-the-money” and becomes worthless. The seller retains the entire premium collected, and no further action or obligation is required.

Option Exercised (Assignment)

The second scenario involves the stock price rising above the strike price, making the option “in-the-money.” In this situation, the option buyer will likely exercise their right to purchase the shares, leading to “assignment” for the seller.

For a covered call seller, assignment means delivering the shares they already own at the strike price, limiting their profit to the premium received plus any appreciation of the stock up to the strike price. The capital gain from the sale of the shares is determined by the difference between the original purchase price of the stock and the strike price, plus the premium received, and is subject to capital gains tax rules based on the holding period of the stock.

For a naked call seller, assignment presents a significant risk of loss. The seller is obligated to acquire the shares at the higher prevailing market price to fulfill their commitment to sell them at the lower strike price. This can result in substantial or even unlimited losses, as the stock price can theoretically rise indefinitely.

Stock Price Near Strike at Expiration

A third scenario occurs when the stock price is at or very near the strike price at expiration. Even if the stock is only slightly in-the-money, the option may still be exercised by the buyer, leading to assignment. Brokers often automatically exercise options that are in-the-money by as little as one cent at expiration. The outcome for the seller in this marginal situation would align with either the covered or naked call assignment consequences, depending on their initial position.

Managing and Closing the Position

Sellers of call options have several ways to manage or close their positions before the expiration date or before assignment occurs.

Buy to Close

The most direct method is to “buy to close” the option. This involves purchasing an identical call option in the market, which effectively cancels the original selling obligation. If the option’s value has decreased since it was sold, buying it back at a lower price results in a profit for the seller. Conversely, if the option’s value has increased, buying it back helps limit potential losses.

Roll the Option

Another strategy is to “roll” the option, which involves closing the current option position and simultaneously opening a new one. This typically means buying back the existing call and selling a new call with a different strike price, a later expiration date, or both. Rolling allows sellers to adjust their position based on market expectations, potentially extending the time horizon for the stock to remain below the strike price or adjusting the strike price to a more favorable level. For instance, a covered call seller might roll an option up and out to a higher strike price and a later expiration date to avoid assignment while continuing to hold their shares.

Assignment Process

If an option is exercised, the seller receives an assignment notice from their brokerage firm, typically after market close.

For covered calls, the broker will debit the specified number of shares from the seller’s account and credit the account with cash at the strike price.

For naked calls, the seller’s account will be debited for the cost of purchasing the shares at the prevailing market price, and then credited with the proceeds from selling those shares at the strike price, reflecting the loss incurred.