Selling uncovered call options
Since speculators who sell uncovered calls typically do not want a short stock position, the writers usually close the calls if they are in the money as expiration approaches. Short calls can be closed by entering a "buy to close" order. The potential profit is limited to the premium received less commissions, and this profit is realized if the call is held to expiration and expires worthless.
Selling a call uncovered requires a neutral-to-bearish forecast. The forecast must predict that the stock price will not rise above the break-even point before expiration. Selling an uncovered call based on a neutral-to-bearish forecast requires both a high tolerance for risk and trading discipline. A high tolerance for risk is required, because risk is theoretically unlimited.
In practice, a sharp price rise can cause very large losses, losses that could exceed account equity. A takeover bid or an unexpected announcement of good news might cause the underlying stock to gap up in price, which could result in such a loss.
Many traders who sell uncovered calls have strict guidelines — which they adhere to — about closing positions when the market goes against the forecast. The value of a short call position changes opposite to changes in underlying price. Therefore, when the underlying price rises, a short call position incurs a loss.
Also, call prices generally do not change dollar-for-dollar with changes in the price of the underlying stock. Volatility is a measure of how much a stock price fluctuates in percentage terms, and volatility is a factor in option prices. As volatility rises, option prices tend to rise if other factors such as stock price and time to expiration remain constant. As a result, short call positions benefit from decreasing volatility and are hurt by rising volatility.
This is known as time erosion. Short calls benefit from passing time if other factors remain constant. Stock options in the United States can be exercised on any business day, and the holder of a short option position has no control over when they will be required to fulfill the obligation.
Therefore, the risk of early assignment is a real risk that must be considered. Sellers of uncovered calls, therefore, must consider the risk of early assignment and should be aware of when the risk is greatest. Early assignment of stock options is generally related to dividends, and short calls that are assigned early are generally assigned on the day before the ex-dividend date.
In-the-money calls whose time value is less than the dividend have a high likelihood of being assigned. If a call is assigned, then stock is sold at the strike price of the call. In the case of an uncovered call where there is no offsetting long stock position, a short stock position is created.
The reason some traders run this strategy is that there is a high probability for success when selling very out-of-the-money options. If the market moves against you, then you must have a stop-loss plan in place. Keep a watchful eye on this strategy as it unfolds.
You may wish to consider ensuring that strike A is around one standard deviation out-of-the-money at initiation. That will increase your probability of success. However, the higher the strike price, the lower the premium received from this strategy. Some investors may wish to run this strategy using index options rather than options on individual stocks. It is not a strategy for the faint of heart.
As long as the stock price is at or below strike A at expiration, you make your maximum profit. Risk is theoretically unlimited. If the stock keeps rising, you keep losing money. You may lose some hair as well. The premium received from establishing the short call may be applied to the initial margin requirement. After this position is established, an ongoing maintenance margin requirement may apply.
That means depending on how the underlying performs, an increase or decrease in the required margin is possible. Keep in mind this requirement is subject to change and is on a per-contract basis. For this strategy, time decay is your friend. You want the price of the option you sold to approach zero.
That means if you choose to close your position prior to expiration, it will be less expensive to buy it back. After the strategy is established, you want implied volatility to decrease. That will decrease the price of the option you sold, so if you choose to close your position prior to expiration it will be less expensive to do so.
Options involve risk and are not suitable for all investors. For more information, please review the Characteristics and Risks of Standardized Options brochure before you begin trading options. Options investors may lose the entire amount of their investment in a relatively short period of time.