I understand how buying them works but I’m looking at selling and it doesn’t seem to make sense. More importantly, what happens when they expire?
In: Economics
One critical difference is that if you buy a call and it ends up in the money, then either you can sell the call to someone else or you can take possession of the underlying security *at a predetermined price*. If, on the other hand, you’re selling calls, you get the sale price of the call up front, and then at expiry if the security is in the money, you’ve pre-agreed to sell at that price, which is fine *if you own the security*. This is referred to as a “covered call” because you can cover the option with securities you own.
Selling covered calls can be a good strategy for increasing your yield: If you’re holding a somewhat volatile security, that you think will close the quarter at around its current value, you can sell a call option up outside the range you think it’ll hit before expiry. If the underlying doesn’t go above that level, you’ve pocketed the option sale price, and after expiry, you can just go ahead and re-sell another call. And if the underlying does go up, you’ve still sold it up, and you can look for a new security you think is now under-priced to hold.
If, on the other hand, you don’t own the underlying security (a “naked call”) and it closes in the money, you’ll have to buy the underlying to cover the option at market price, which, since the option is in the money, is higher than expected. Your potential downside here is UNLIMITED. Never sell calls on securities that you don’t own (not that your broker is likely to let you anyway).
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