What Is Selling a Call Option and How Does It Work?

Options are financial contracts that provide a buyer with the right, but not the obligation, to buy or sell an underlying asset at a predetermined price within a specific timeframe. These contracts involve two parties: a buyer who acquires the right and a seller who grants that right. Selling a call option represents one side of this financial transaction, where an individual or entity takes on an obligation in exchange for immediate payment. This article explains what selling a call option entails from the perspective of the seller.

Understanding Call Options

A call option grants its buyer the right to purchase an underlying asset, such as shares of a company’s stock, at a specific price, known as the strike price, on or before a particular date, which is the expiration date. The buyer pays a sum of money, called the premium, to the seller for acquiring this right. The underlying asset is the specific security or commodity upon which the option contract is based.

The strike price is the fixed price at which the underlying asset can be bought if the option buyer chooses to exercise their right. For example, a call option on a stock with a $50 strike price means the buyer can purchase that stock for $50 per share, regardless of its market price, until the expiration date. The expiration date marks the final day the option contract is valid. The premium is the upfront payment the option buyer makes to the option seller for the privilege of holding this contract.

The Mechanics of Selling a Call Option

When an individual sells a call option, they are effectively taking on the obligation to sell the underlying asset at the predetermined strike price if the option buyer decides to exercise their right. In return for assuming this obligation, the seller immediately receives the premium from the buyer. This premium is the seller’s primary financial gain from the transaction if the option is not exercised.

The seller’s objective is for the option to expire worthless, allowing them to retain the full premium received. This occurs if, at the expiration date, the underlying asset’s market price remains below the call option’s strike price. In such a scenario, the buyer has no financial incentive to exercise their right to purchase the asset at a higher price than it is currently trading, and the option simply lapses.

If the underlying asset’s price rises above the strike price by the expiration date, the buyer will likely exercise the option. In this situation, the seller is obligated to sell the underlying asset at the agreed-upon strike price, even if the market price is significantly higher. The premium received by the seller helps to offset any potential loss if they must acquire the shares at a higher market price to fulfill their obligation.

Covered Versus Naked Call Options

Selling a call option can be undertaken in two ways, distinguished by whether the seller owns the underlying asset. A covered call is established when the seller already possesses the number of shares of the underlying asset equivalent to the option contract. For instance, one standard option contract represents 100 shares of stock, so a covered call seller would own at least 100 shares of the particular stock. This ownership “covers” the obligation to sell, meaning if the option is exercised, the seller can fulfill their commitment by delivering the shares they already own. Individuals often sell covered calls to generate additional income from their existing stock holdings.

In contrast, a naked call occurs when the seller writes a call option without owning the corresponding underlying asset. This means if the option buyer exercises their right, the naked call seller must acquire the underlying asset in the open market to fulfill their obligation. This acquisition would occur at the current market price, which could be substantially higher than the strike price. Brokerage firms impose higher margin requirements for naked call positions, demanding a significant deposit, often 20% or more of the underlying asset’s value, to mitigate the increased financial exposure.

Outcomes at Expiration

At the expiration date, a sold call option will resolve in one of three ways, impacting the seller differently. One common outcome is for the option to be out-of-the-money (OTM), meaning the underlying asset’s price is below the strike price. In this instance, the option expires worthless, and the seller retains the entire premium received from the buyer.

If the underlying asset’s price is above the strike price at expiration, the option is considered in-the-money (ITM), and the buyer will likely exercise it. For a covered call seller, this means their shares are “called away”; they are obligated to sell their owned shares at the strike price. The premium received effectively reduces the cost basis of those shares or adds to the proceeds from their sale.

For a naked call seller, an ITM option exercise presents a different scenario. The seller must purchase the underlying asset at its current, higher market price and then immediately sell it to the option buyer at the lower strike price. This scenario can result in a substantial loss for the naked call seller, as the cost of acquiring the shares can far exceed the premium received. If the underlying asset’s price is exactly at or very close to the strike price at expiration, known as at-the-money (ATM), the option typically expires worthless unless it is slightly in-the-money, as the cost to exercise may outweigh any minimal gain.